For proof of the first claim - that excessive leverage and too much debt cost Australian investors billion of dollars - read today's essay "Pigs at the Trough" by guest essayist Adam Schwab. Adam's got a new book out by the same name. And he makes a great point: Australia may not have learned much from the first round of the GFC.

But is there really going to be a round two? Well, if the first incorrect assumption was that Australia didn't have a bad debt problem, the second assumption is probably even more dangerous. It's more dangerous because it's the single most unexamined assumption behind much of Australia's economic prosperity. The assumption is that we'll always have China.

A growing number of professional investors are betting against China. It's true that all of these investors - short-seller Jim Chanos, our friend Dr. Marc Faber, Harvard Professor Ken Rogoff - are all talking their book to some extent. We all do that all the time. But that doesn't invalidate our arguments.

And the argument is simple: China's economy is the Greatest Bubble on Earth. James Rickards, the former General Counsel for the famously-failed hedge fund Long-Term Capital Management, told Bloomberg that China is in the midst of "the greatest bubble in history." He said the Chinese central bank's balance sheet, "resembles that of a hedge fund buying dollars and short-selling the yuan." "As I see it, it is the greatest bubble in history with the most massive misallocation of wealth," he told the Asset Allocation Summit Asia 2010.

Students of the Austrian School of Economics would identify with the comment. Credit bubbles - and the world has arguably been in one long once since the U.S. dollar could no longer be redeemed for gold internationally in 1971 - know that credit creates excess demand. It gives producers a false impression of the consumer appetite for goods and services. Real resources are poured into providing people with products they buy with debt-based money.

When the bubble bursts, the demand goes too. This is why Australia's government, slavishly obeying Keynesian dogma, has tried to "bring demand forward" or "support aggregate demand"
by giving away the nation's surplus. And once it was finished doing that, it borrowed (stole) from the future in order to support demand.

But this just perpetuates the misallocation of resources (in this case, stealing tomorrow's savings to support today's consumption.) In China's case, however, the misallocation of resources is even more impressive. There is massive over-capacity in commercial real estate with millions of square meters of vacancies. Whole cities lie empty.

These cities and office buildings were made with Australian iron ore and coking coal. If China's miracle economy (regularly achieving politically mandated 8% GDP growth to support employment) is really the world's largest collection of misallocated resources ever, then what do you think will happen to Australia's economy?

On the verge of another big increase in contract iron ore prices, it may seem like a strange time to ask the question. But it's probably the most important question Australian investors could ask themselves this year. "What can I do to protect myself against a crash in China?"

The possibility may seem remote. But remember, no one in the mainstream media or economics profession warned you of the GFC either, did they? Even if you think it's unlikely or absurd, it's probably something you should think about a bit. We've thought about it and we think the best answer is to retire now.

But what does that really mean? It means you should own a lot fewer stocks. But yes, that does contradict the rosy projections for Australia's super annuation system. Australia's super system is projected to have nearly $5 trillion in assets by 2025 according to an article in today's Australian.

Chris Bowen, the Minister of Financial Services, spoke by video to a conference in Brisbane. He didn't say where all the super money would go specifically. But he did say, "This might mean greater investment in infrastructure assets, provided a stable pipeline of opportunities was available."

Now you may want your money to go into infrastructure assets. And if you do, more power to you. After all, they are tangible assets. But you can't put a bridge in your refrigerator. Portable tangibility - wealth you can wear, store, or trade - is the name of the game as you reduce your allocation to deflating financial assets ahead of the hyperinflation. More on that Big Crash two-step in Friday's letter.

Dan Denning
for The Daily Reckoning Australia

• Australian Iron Ore Shares on China’s Menu
• The ASX Bubble, Fueled by China
• Building a National Economy Around the Housing Industry
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package
• The Price of Oil is in a Bubble

First up is gold's 1.27% decline in the futures markets. We've written about this in a special note that goes out later today. If you miss that note here's the short version: don't worry. The fear that China won't buy IMF fold is a red herring. China is buying plenty of gold. But you might be surprised to find out who the seller is.

What shouldn't surprise you is that fewer Australians are taking out mortgages to buy new homes. That's what happens when prices rise, interest rates head up, and the government stops shovelling tax payer money into the market. You can only "bring forward" (steal) so much demand from the future.

The number of people taking out loans to buy new homes fell by nearly 8% in January, according to the Australian Bureau of Statistics. First home buyers fell as a percentage of new lending to 20.5%. That's down from the high of May last year of 28.5%. And here in Victoria, only 525 Victorians borrowed money to buy a new home in January (see the table on page 10).

Don't be discouraged, though. The Reserve Bank agrees with the realtors and housing industry spruikers that there is a housing shortage in Australia. RBA assistant governor Philip Lowe said in a speech in Sydney yesterday that constraints on home building are restricting the supply of homes in Australia. The shortage is one factor keeping prices up. Nothing was said about the lending boom.

Lowe said that, ''With population growth above average, and growth in the housing stock below average, it is not surprising there has been upward pressure on housing costs...If we are to build more dwellings, we need to ensure that planning guidelines and infrastructure provision can accommodate this.'"

Blah blah blah. We're not going to rehash all of this again. But if anything, Australia has already sunk too much of its national capital into housing. Maybe investors have over-invested and locked out first time buyers while also damaging affordability. Who knows?

The river of liquidity that has floated Aussie house prices higher has its source waters overseas in the wholesale borrowing by Aussie banks from foreign lenders. This is what accounts for the financial sector's massive share of Australia's net foreign debt. Another global credit squeeze (the implosion of the shadow banking system) would block off those head waters. And where would that leave Aussie housing?

This is not to say or imply that homeownership is an unworthy goal. Yale Economist Robert Shiller points out in New York Times article that home ownership can promote good citizenship, a broad sense of equality, and even a sense of personal liberty in a society. That's why in Australia and America, homeownership is THE personal financial dream.

But Shiller also points out those are cultural and not financial values. The desirability of homeownership shouldn't be confused with the financial wisdom of it. The more leveraged a housing investment it is, the more vulnerable you are to getting wiped out on falling asset price falls. This is why nearly 16 million Americans are underwater on their mortgages.

In the mortgage boom years from 2004-2004, it wasn't hard to get a loan-to-value ratio of 90% or higher with less than a 5% down payment. You didn't have any equity. But the animal spirits of the housing bull encouraged people to believe prices would just keep going up.

They didn't, of course. And instead of having equity, most of the borrowers ended up with a big mortgage and a falling asset. This is what soured so many mortgage backed securities and collateralised debt obligations. And the fact that Americans can walk away from underwater mortgages - letting the bank seize back the house, which is the collateral on the loan - in some ways made the financial gamble sensible for people. Maximum upside, zero downside.

You can't walk away from the loan in the same way in Australia. But that doesn't' mean Australians aren't gambling on higher house prices. Loan-to-value ratios are coming down as banks get more cautious (this restricts new lending as well). But they are still high. And first home buyers remain especially over-leveraged - facing higher interest rates on variable rate loans.

But you know all that. So we won't yammer on about it. We're just saying...house aren't safe as houses, no matter what the RBA says.

So what is safe? Well, as a reader pointed out yesterday, cash isn't bad. Here's one response to yesterday's essay:

Hi guys,

John Pope

It's a good point. We'll deal with it tomorrow. Although it's going to be hard to predict the future...in detail. That won't stop us from trying! Until then.

Dan Denning
for The Daily Reckoning Australia

• General Motors: A Forerunner for What’s to Come for the Broader Economy
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• Are Aussie House Prices in a Bubble?
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• Underlying Demand During a Housing Shortage

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

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

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

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

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

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

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

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

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

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

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

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

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

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

It's easier than it sounds.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Dan Denning
for The Daily Reckoning Australia

• Credit Markets Threaten Retail Banking, Bank Runs Next?
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Anyone can make a mistake, but to really make a mess of things you need taxpayer support. Well, now the feds are getting plenty of it...

Over the last decade, federal spending in the US has gone from less than 35% of GDP to well over 40%. In Britain, the increase has been even more dramatic, from about 36% of GDP to nearly 55%.

Not only are the feds taking up a bigger percentage of GDP, they're also becoming bossier. During the Bush years the federal register recorded 7,000 more pages of new rules.

And, of course...they're making a monumental mess of things. They're spending money they don't have on things no one in his right mind would pay for with his own money.

Want an example? Go to Jonestown, Pennsylvania. They've got an airport there that is the envy of travelers everywhere. Lots of airport, in other words...few passengers. That's because John Murtha - when he was still among the quick - used his power in Congress to build an airport that would be convenient for him...and reward local contractors and unions who had supported him over the years.

Few politicians dug more deeply into the pork barrel than John Murtha. But almost all stick their hands in it. Why else would you bother with the trials and tribulations of 'public service?' There's got to be a payoff that makes it worthwhile, right? Of course, there are a few - like our friend Ron Paul - who are just trying to do the right thing. But for every Ron Paul there must be dozens of Congressmen and federal employees who are in it for the power, the money - or both. (Neither Stalin nor Hitler squeezed much personal wealth from the taxpayer tube. Mao Tse-tung, on the other hand, knew how to live - with plenty of palaces and young women. Most government employees are probably more like Mao than Adolph. That is, they are motivated by money as well as power.)

Have you wondered why the costs of running for public office have soared? That's obvious too - because the stakes are higher. As the federal budget grows so does the pork that each member of congress can pull out of the barrel.

The number of congressmen is more or less constant (though it grows with population...after a 10-year lag for the census). But the amount of money given out increases...making each congressional seat more lucrative. You can do the math yourself, but the point is - crime pays. At least, for a while...

The trouble with crime is that it only makes the criminals rich. Everyone else gets poorer. That's the problem in places such as Nigeria and Haiti. Crime pays. Nothing else does. Economists have done studies of this...and, of course, they've discovered the obvious. In "high trust" societies, people are wealthier. No wonder; when people know they won't be ripped off, they accumulate more money.

A high trust society is one where property rights are respected...and where the rules of the game are known...and change very slowly. A change in tax rates, for example, discourages wealth - especially if it comes unexpectedly. So does a change in monetary policy. When people don't know what to expect from the currency they become reluctant to invest for a long-term payoff. Instead, they invest in lobbying.

For the most part, tax rates haven't gone up. Instead of taxes, government gets its money from borrowing. The immediate effect is much the same; resources are absorbed out of other sectors of the economy and into the public sector. Once in government service, they are used inefficiently or completely squandered. Result: John Murtha gets an airport...a kid in Brooklyn doesn't get a bicycle... The long-term effect is unknown...but will almost certainly be unwelcome. The government will eventually be unable to borrow at low rates...and unable to finance its deficits. This will result in default...or hyperinflation...or both. In anticipation, trust in the future will go down...and so will America's wealth.

That's why the shift to politics is the FINAL stage of an economy... It is inherently wealth-destroying. In politics the rewards are distributed according to who you know or who you are. What you know and what you can do scarcely matters. Trust declines...because the rules change as wealth is taken away from some and given to others. The incentive to produce new wealth declines. Investments in new capital, new businesses, new innovations and so forth go down. Investments in lobbying go up. The insiders get rich. The rest get poor. And the nation's wealth declines...along with its economy and its power. This will continue until the political sector blows itself up - either in default, bankruptcy, hyperinflation, revolution or defeat by a foreign power. Then, the cycle can begin again.

Regards,

Bill Bonner
for The Daily Reckoning Australia

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"Japan Deflation Hits a Record Pace," reported the BBC. Prices in Japan were falling faster than they ever had since they began keeping track in 1970. The tide has gone out so far; beachcombers can't remember when there was so much beach to comb. But what follows is not offered as a prediction, but only out of curiosity. We don't know how this will turn out. Could it end in hyperinflation? Maybe.

Prices fall in Japan. The yen rises. And the government uses every trick in the book - and some as yet unpublished - to knock it down. If you are in a position to borrow money from the central bank, the bankers will give it to you at practically zero interest. And if your neighborhood wants a bridge or a community center, that too will be forthcoming from the Japanese government. No government has ever been so generous. At least, not without going broke. For every yen the government squeezes from its taxpayers, it returns more than 2 yen in public spending.

Investors must think the trend is eternal. Or perhaps they don't think at all. They lend money to the world's most spendthrift major government for 10 years in exchange for a yield of only 1.310%.

The drama of this story is an old and familiar one. Deeply flawed heroes at the world's central banks and treasury departments think they can do a better job of guiding the economy than the markets themselves. It is they who set the price for short-term money, for example, not willing borrowers and lenders. They are the ones who fight the correction every inch of the way. They are also the ones you don't want to stand behind; every shot they take backfires.

In France, the savings rate, as percentage of revenue, has gone up for the last 16 months, to 17% - the highest rate in 27 years. This comes as the Sarkozy government follows the lead of the US and Japan, with a deficit of about 8%...compared to 10% in the US and even higher in Japan. This is not the first time this has happened in France. The previous savings rate peak came when the Mitterrand government was trying to stimulate the economy out of the slump of the early '80s. The more the government tries to stimulate spending by running deficits, the more people try to protect themselves by saving.

While the drama continues throughout the world, the story is most advanced in Japan. Which is to say, the central bankers have gotten themselves into deeper trouble. Martin Wolf of The Financial Times and Richard Koo of Nomura Securities applaud their performance. But by trying to suppress a correction in the private sector, Japan's central bankers have stretched out a slump over two decades and set up the nation for a bigger crisis in the public sector. And there is nothing they can do about it. Their fiscal stimulus no longer stimulates. Their monetary inflation no longer inflates. And every quack cure they offer brings the patient closer to the grave. You might think they'd give up. Instead, they increase the dosage. Fiscal stimulus hits a new record, right along with deflation.

But it's the final act that interests us. With public debt at nearly 200% of GDP and 700% of tax revenues, we shouldn't have to wait much longer. Given the track record, we have to assume that it will be the exact opposite of what central bankers expect. They are aiming for the whimper of newborn growth. More likely, they will get the bang of hyperinflation.

The Japanese were recently among the champion savers of the world. Directly or indirectly, these savings financed the government's stimulus efforts. Banks, pension plans, insurance companies - all bought government bonds as a safe way to store wealth. The government then drew upon this stored up wealth to finance its bridges to nowhere and its other boondoggles. The result is a misunderstanding on its way to becoming a disaster. The typical Japanese person looks forward to his retirement with a mountain of savings in his backyard. He believes he still has his cake. The government, however, has eaten it.

Higher savings rates typically produce lower prices, for a while. Currencies rise. Even in Weimar Germany, there was a period in 1920 when the mark rose. Falling prices would seem to be proof that the money is still there. But the real money is gone. Then, suddenly, people notice that their savings are nothing but paper. The tide turns. Confidence disappears. The big wave of accumulated savings hits the marketplace like a tsunami. Desperate people try to get rid of paper. They want something solid to hold onto. Long-term bonds, the most vulnerable to inflation, are exchanged for cash. Cash and government securities flood the market. Prices soar. Middle-class savers drown. Meek debtors, relieved of their burdens in the flood, inherit the world. So do the arrogant debtors in the government. And the shrewd speculators. And then central bankers return to their desks and come up with a new plan.

Regards,

Bill Bonner
for The Daily Reckoning Australia

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Yes, dear reader, even our heroine, Angela Merkel, is joining the fools' parade. In a front-page feature in yesterday's International Herald Tribune we learn that Ms. Merkel is bringing Germany in line with the rest of the world - by increasing the public deficit to over 6% of GDP.

"Germany chooses growth over paying debt," says the misleading headline.

But 6% is only half the US level...and the UK is nearing 15%!

The raw news: the Dow fell 93 points yesterday. Gold held above $1,100. There's no sign of panic. But we keep our Crash Alert flag flying anyway; you never know.

We're in Rome...actually in the airport...on our way back to London. Alitalia offered the best deal to Buenos Aires. But the plane was a disappointment. The food was good; the hostesses were pretty; but the seats in business class didn't fully recline. After the first 10 hours, we were very uncomfortable. And pity the poor folks in economy!

But if you want to be an "international man," as our friend Doug Casey termed it, you have put up with some inconvenience. Why would you want to be an "international man?" As another old friend, Marc Faber, observes, it pays to travel. You get a broader perspective. And you realize that many things your compatriots take for granted others take for absurd. "The more you look, the more you see," is our dictum.

One thing Americans take for granted is that they will always be the richest, most successful people on earth. They think that because that is what they have always known. The US economy became the biggest in the world before 1900. Americans had just what it took to become the richest people on the planet. They worked hard. They saved their money. They had little government interference. They had the industrial revolution at their backs...and nothing in their way. And they had a dollar that was 'as good as gold.' By the time the baby boomers were born the US had such a big lead over the rest of the world, it seemed like nothing could stop it. Free enterprise guaranteed new innovations and new wealth. Democracy guaranteed a political system that would adapt to the needs of the evolving economy.

But nothing lasts forever. As it matured, the US economy and its political system became more and more rigid and more and more costly, with handouts and bailouts...at every level. Large companies are protected. Millions of people are encouraged not to work. The whole financial industry is dipped in honey. And the whole population is urged not to save, but to spend. Why bother to save for retirement; there's Social Security. Why bother to save for health care emergencies; there's the government's new overhaul of the medical system! Why bother to save at all; the government has fixed short-term rates so low you get nothing for your trouble.

On our travels what we notice is that there are a lot of smart people in the world. And they're all sweating, striving, and angling to get ahead. You never know who will win the race, but you can be sure that no one will stay in the lead forever.

"US Wages Out of Balance," says The New York Times. It is pointing out the obvious. Americans are paid too much, compared to other people in the world who work just as hard and who now - thanks largely to the feds - have as much or more capital than we do.

Wages in the US will come down - probably thanks to unemployment and inflation. So will US living standards compared to the rest of the world.

Meanwhile...back to Angela...

Generations of German central bankers learned their lesson. They saw what happened when hyperinflation ran wild in the '20s. The middle class was wiped out in a matter of days. People lost faith, not only in the Deutsche Mark, but in Germany itself...and in all the old values. The next thing they knew, the Chancellor was wearing a silly uniform and they were on the road to Hell.

More recently, the last generation of German central bankers worried about the euro. They had no doubt about themselves. They had the backbone to protect their new currency. But what about the Italians? And the Greeks? And the Irish?

Well, they can fret no more. Now, the German deficit is higher than the Italian deficit.

Why would they do such a thing? They have the usual poppycock explanations - countercyclical spending, the need to maintain social services as tax revenues fall, the need to bailout the East, (see below) etc. But the real reason is that the old German economists are dead. One of the last of them was our colleague Kurt Richebächer.

Every time we saw him, Kurt would complain about American and English economists.

"Ya...you Anglo-Saxon economists are ruining the world," he would say. Kurt had no truck with Keynesianism. Or monetarism. Or any other of the fads in economics. Besides, he had lived through Germany's hyperinflation, the rise of National Socialism, WWII, partition, and finally, reunion. He knew that there were no free lunches...no easy fixes...and no panaceas. He knew too that people who promised miracles were dangerous frauds. Wealth is created by work...saving...innovation...investment...and perseverance. There are no miracles. No short cuts.

While wealth is created by work and saving, it is destroyed by consumption and debt. When you borrow money, you have to pay it back. Then, you must draw down your wealth...reduce your living standard...and cut into the capital you laid away in years past. You can try to squirm and dodge...but you just make the situation worse.

Kurt was right.

But now Kurt is dead. A new generation of economists has taken over. Born after the war, they know hard times only from movies and history books. They haven't forgotten the old truths; they never learned them. Instead, they probably did their training at Harvard or Chicago...and studied nonsense...such as the Efficient Market Hypothesis and Modern Portfolio Theory.

They think the key to prosperity is spending. Consumers spend until they can't go on. Then it's up to the government. That's why the Germans are running such a high deficit. The think they need to keep up spending - at all costs - in order to boost the economy. As Kurt used to point out, it makes no sense theoretically...and there's no evidence that it works in practice either. Every time governments have intervened with large dollops of countercyclical spending they have made a mess of things...either by stimulating the private sector to further acts of reckless insolvency...or by blocking the process of correction.

It's all claptrap. Angela, you should be ashamed of yourself.

Bill Bonner
for The Daily Reckoning Australia

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But wait...what's this? The average maturity of that debt has come down from more than 5 years to only 4. And according to the Office of management and Budget, if the US continues on its present course, net interest will rise to 5% of GDP in 2019 and 10% in 2034.

And that assumes there is no big increase in interest rates...and that the economy recovers as planned. If either of those things fails to happen, the situation will degrade fast.

Imagine if the government were forced to refinance debt at double-digit interest rates - as it was in the late '70s. Net interest could go to 5% of GDP within months.

We're in a depression, not a recession. Depressions take longer to sort out. But they are also far more treacherous. Because there are always periods when things seem to be going "back to normal," only to go back down again as soon as investors turn bullish.

Richard Koo, author of The Balance Sheet Recovery, recalls how it was during Japan's long, dark passage:

"We had these false starts... The economy would begin to improve and then we'd say 'oh my god, the budget deficit is too large.' Then we'd cut fiscal stimulus and collapse again. We went through this zigzag for 15 years."

Koo understands what is going on, more or less. Companies and households are paying off debt. He and Paul Krugman believe the feds have to continue pumping money into the system or they're going to have a "lost decade," just like the Japanese.

You have to keep the stimulus money flowing "until the private sector de-leveraging is over," he says.

By our calculations, it will take 5-10 years for the private sector to de-leverage. By that time, the feds will have added trillions in debt to public finances. Since they can't finance that much from private domestic savings, and since foreigners will be wary about lending that much even if they had it, the Fed itself will have to pony up the money. This will put the dollar in further danger...along with the entire global financial system.

Koo may be right - as far as his thinking takes him. He should think a little further. The problem is debt. Too much debt in the private sector caused bear markets and a bank crisis. Too much debt in the public sector will cause big problems too - a default...and hyperinflation. Worse than a depression.

Bill Bonner
for The Daily Reckoning Australia

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Here at The Daily Reckoning we may hate the devil and renounce all his works...but we're betting on him anyway...

Let's begin with the headlines:

"Financials Slam Wall Street," says a headline. The Dow fell 92 points. Makes us think the financials didn't slam it very hard.

Gold rose. Oil rose. And the dollar sank below $1.50 per euro...another milestone.

As we reported yesterday, investors think the recovery is for real...and that it will boost up prices of commodities and stocks. The dollar, on the other hand, is chopped liver.

But we have a feeling that the devil is on the side of the dollar. Let's us explain.

"How Wall Street Will Kill the Recovery," is a headline at BusinessWeek.

Finally, everyone is catching on to how it works. The big banks take the feds' money...then they speculate with it ...or lend it back to the Fed for an easy 400 basis points of gain.

At Seeking Alpha, they're talking about "the return of Japan's zombie finance." Over at The Wall Street Journal they've talking about America's own "Zombie banks."

But these monsters are only reacting to the jolt of juice given them by the Dr. Frankensteins at the Fed and the Treasury. It has become very unprofitable to hold cash; the feds are creating more of it by the boatload. You get a minimal rate of return on cash...while other assets go up. And the feds can't stop...or change course...not without sinking the whole economy. They may talk about an 'exit strategy.' But the exits are blocked. Remember cash is created when the feds "monetize the debt" by buying US Treasury bonds. In order to exit...that is, in order to reduce the monetary base...they'd have to sell those bonds back into the open market.

Are you kidding, dear reader? After being the single largest buyer on the planet? Imagine what will happen to the bond market when investors realize that the Fed is selling! It's not going to happen. Instead, that $1 trillion increase in the monetary base is more or less permanent...and it's eventually going to turn up as inflation.

The feds have no idea what is going on. They consistently misunderestimate the devil...the market...and the economy. And they consistently misoverestimate themselves.

In short, the old timers were right. To them, an economy was a natural thing...like an eco-system...or a language. It followed natural rules...rules that no man could change. It was like a living organism. It needed to breathe in and breathe out. And like all things under heaven, it was subject to moral laws. Do the wrong thing and you (an economy...as well as an individual) will pay the price. You don't get what you want from markets...you get what you deserve.

This seemed intuitively correct to generations of economists. Not only that, it was proved correct time and time again. Each time people borrowed too much and spent too much money, they came a cropper.

You may ask: "How much is too much?" According to the record, compiled and analyzed by professors Reinhart and Rogoff, it's impossible to say exactly. One nation can support public debt of 200% of its GDP (Japan comes to mind)...another cracks up at 50% (think of Argentina). A man like Donald Trump can carry millions in debt...another goes broke if you lend him 20 bucks.

(At one point Donald Trump was the poorest man in the world. His net worth was negative by 10s of millions (we don't recall the figure). All over the world, hundreds of millions of people could have said: 'I'm richer than Donald Trump.' Even if you didn't have a dime, you were richer than The Donald.)

So, how much is too much debt? It depends on what you use the money for...how much you have in assets...whether your earnings are shrinking or growing...and a number of other questions. But while the answers aren't simple, the questions should still be asked: If you run up a debt, how are you going to pay it back? What will happen if you don't pay it back?

A professor at the University of Basel, Peter Bernholz, thinks he has the answer. He studied instances of hyperinflation. He believes that you get hyperinflation any time the government spends 166% or more of what it receives in revenues. This should set off alarm bells. The US budget is now about 170% of tax receipts.

The feds can't repay the record amounts they're borrowing - not without a major political crisis. They'd have to cut spending and raise taxes so dramatically it would cause a backlash. The parasites would revolt. It would probably unseat the ruling party and break the repayment plan. Generally, people prefer inflation...or default...to actually paying their public debts.

One way or another, however, the devil debt will have his due. Somebody is going to pay - if not the borrower...then surely the lender. There's a bullet out there. Someone has to take it.

But who believes it? The old economists are dead. John Maynard Keynes denied that debt mattered very much. Then, his successors forgot that it mattered. Dick Cheney told his party to stop worrying about it. And now a whole plethora of modern economists and politicians believe that the problem with today's economy is that there is not enough of it. Debt that is. They think the government should borrow and spend even more. To them, the whole secret to a healthy economy is how much money people spend. Yes, it's absurd, but that doesn't make it unpopular. People like spending money. And they welcome economists who tell them that they're doing the right thing.

Since Keynes, economists pretend the devil doesn't exist. They believe they are not part of nature...controlled by natural laws. Instead, they want to take control of nature. And the only way they can get a grip on economies is to break the boom-bust business cycle. And you can't do that unless you pretend that debt doesn't matter.

The trouble with real markets is that they are always subject to human emotions and human calculations. It is a quality that George Soros describes as "reflexivity." Markets act differently, depending on what people believe. And when the authorities try to turn their knobs and yank on their levers, it changes both what people believe and what they do - but not necessarily in the way the feds want.

It is much easier to manipulate speculative markets than it is to manipulate the real economy. Want to drive up prices? Just give speculators some free money to play with! Guarantee their debts! Bail them out of their stupid positions! That's what the feds have done. And that's why the banks - the recipients and conduits for the free money - are making profits. Goldman allocated $527,000, per employee, in compensation for the first 9 months of this year. An increase of 46% over last year.

Gold, oil, copper, stocks - all are in government-induced speculative booms. But the underlying economy is harder to move. In order to get consumers to spend, the feds have to put money into their hands...and raise prices so consumers will want to get rid of it, rather than hoard it. But that is proving very hard to do.

Why? Because of the debt. Consumers have to pay down their debt. They have to cut back. They have to spend less. So, the economy shrinks.

And now The Wall Street Journal is talking about another downdraft in the housing market. It could get "even uglier" it says. Why? The mortgage debt that still have to be reset and rescheduled. Apartment rents are falling as unsold units are put up for rent.

Sales at luxury stores go down as consumers work their way back down the price chain. Why? They have to spend less as they pay off their debts.

Yes, you can ignore debt...until you go broke!

Bill Bonner
for The Daily Reckoning Australia

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"We are sinking in a sea of debt," he admitted. And on the very day when France's president, Nicolas Sarkozy, said he would not raise taxes, Osborne said that he would not lower them. In order to lighten Britain's debt, he'd leave Labor's 50% maximum tax rate right where it is.

Voters don't like hearing about debt. Politicians don't like talking about it. And economists don't want to think about it. And in a kind of collective suicide pact, they have all agreed not to worry about it. But debt is at the center of the world's financial troubles.

Paying off debt is like dying. You try to put it off as long as you can. But nobody runs an open tab forever.

This week brought news that Maine-based luxury yacht maker Hinckley, which has been building boats since 1928, is sinking. The problem is neither technical nor operational. It is philosophical. No one complains about the quality of the boats. Or even the prices (if you have to ask, you can't afford one). The company sailed along nicely until 1997. Then, the private equity hotshots from Boston took the helm. The old Hinckleys who ran the shop looked upon debt as though they were looking at a bottle of whiskey. A drink now and then did no harm. But watch out. Too much will sink you. In the 70 years they ran the place, they accumulated only $1 million of debt. But the new owners were dipsomaniacs; they multiplied Hinckley's debt 20 to 40 times. (Exact figures are not available.)

For much of history, failing to repay debt was regarded as not merely a breach of contract, but a crime. People who failed to repay their debts in timely fashion were thought to have stolen from their lenders; they were put in prison. In the Middle Ages even a dead debtor's children could be sent to prison.

Now, bankruptcy laws allow individuals and businesses to go to rehab. Then, they can stiff creditors again. Neither sin nor crime, debt is now just a cost of doing business.

But few creditors are as forgiving - or perhaps as forgetful - as those who lend to governments. That is the conclusion of a new book by Carmen Reinhart and Kenneth Rogoff, This Time It's Different. The two professors document the history of eight centuries of "financial folly." What we learn from it is what we already knew - that borrowers are often perfidious, crises are usually insidious, and bankers are morons.

Just five years ago, Ben Bernanke looked out on the calm seas of the Bubble Era. "The Great Moderation," he called it. Bernanke took the credit. It was due to "improved macro-economic policies," he said. In retrospect, he probably should have said it was just luck and left it at that. His macro-economic policies made things worse, encouraging all sectors of the economy to borrow. We know what this did to Hinckley. Riding low in the water, with too much debt heaped on its deck, the yacht maker struggles to stay afloat.

But what's new, ask Reinhart and Rogoff? Always and everywhere, debt leads to trouble. Too much debt caused France to default on its sovereign debt eight times. Spain defaulted six times before 1800 and then another seven times later.

Latin America, as the authors point out, would have been safer for bankers if the printing press had never made its way across the Atlantic. Between hyperinflation, defaults and banking debacles - over two centuries - the banana republics scammed banks out of billions. In the '80s, Nicholas Brady tried to rescue New York bankers with his US- backed "Brady bonds." Readers of these back page columns can guess what happened next. Within a few years, seven of the 17 countries that had undertaken a Brady-type restructuring had as much or more debt than they had before. By 2003, four members of the Brady bunch had once again defaulted and by 2008 Ecuador had defaulted twice.

Even non-existent countries go broke. In 1822, "General Sir" Gregor MacGregor issued bonds from a fictitious country he called Poyais, whose capital city, Saint Joseph, was described by the offering prospectus as having "broad boulevards, colonnaded buildings and a splendid domed cathedral." The bonds sold at lower yields than those of Chile. But it didn't matter whether the country was real or imagined, all of them defaulted.

As for the present slump, the authors offer no predictions, but some guidelines. In the run-of-the-mill crisis, real housing prices generally go down 36% over a six-year period. GDP, in real terms, per capita typically goes down 9.3% while unemployment rates go up for five years, with a 'normal' increase of about 7 percentage points. But the closest parallel to the present circumstance, which they call 'the Great Contraction,' is the Great Depression of the 1930s - which was much worse. Unemployment in Germany and Denmark rose over 30%. Building activity fell 82% in the United States. Chile saw a 90% collapse in its exports.

Tax revenues fall in an economic slump. Government expenses increase (especially when the authorities are ready to do 'whatever it takes' to stir a recovery). Typically, say Reinhart and Rogoff, public debt increases 86% over a three-year period following a financial calamity. Then come more catastrophes, caused by too much debt in the public sector. Both Britain and America are now running deficits of more than 10% of GDP. Neither has a creditable plan for reducing debt or deficits. So stay tuned. Much more trouble lies ahead.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

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We're not sure if there are still places available. It's free, but you'll have to RSVP. You can do so here. It's a great chance to hear two independent thinkers offer an alternative explanation for what's going on, an alternative to the rosy everything's fine clap trap in the mainstream.

If you're not in Melbourne or can't make it, don't worry. We're going to take up some of Dr. Hudson's main contentions over the next month and "unpack them" as the saying goes. Among other things, he's arguing that we are moving to a "Neo-Feudal" world where the landlords and the bankers are again in charge of the economy (and the world).

Their strategy is to get the rest of the country into as much debt as possible. Whether this is so they can increase their claims on financial wealth (rents, interest payments, and capital gains on asset prices) or whether it's a political program to subjugate the population...that's one of the questions we were going to ask.

We were also going to ask if the "de-industrialisation" of advanced Western economies that Dr. Hudson talks about is a reversible process. Can Europe and America ever compete with China and Asia in manufactured goods? And if they can only do so in high-end goods (capital goods, technology, aerospace, IT etc.) what does that mean for the structure of employment in Western economies and corporate earnings.

Dr. Hudson, it seems to us, is right to point out that there is a kind of "Financial Oligarchy" that seems to be benefitting the most from the financialisation of the economy. But everyone else - those betting on higher share and house prices to pay for retirement (and pay off huge debts) - may not fare so well. What should you do? What can you do? More on this in future reckonings.

For today, we'll go to the mailbag and see what your fellow readers have to say.

Dear Dan,

Dear Dan

Hi,

From another Ralph...

Hi

Ralph F.
Little Hartley, NSW Australia

Dan Denning
for The Daily Reckoning Australia

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