Obama to California: Uh...

Yesterday, stocks lost 103 points on the Dow. This looked like a confirmation to us. The stock market appears to have begun its next and final phase...

AP seemed to think so too:

"Stock investors see threats from all directions," said the headline.

We didn't bother to read the article. We already know the directions.

From the north, investors worry about falling consumer demand. Consumers are in a funk - they have more debt, less income, fewer jobs, and less access to credit. The only news on that front we have today is that even jumbo housing loans are going bad...delinquencies are up to 9.6%.

From the east, investors worry about the continued invasion of cheap consumer goods and cheap services. China's economy is said to be growing at double-digit rates. How can US firms compete? And what if China is a bubble, as Jim Chanos believes? When it blows up, US stocks will come down too.

From the south comes the threat of higher interest rates. The poor dopes think the recovery might be for real. If so, inflation will rise and the feds will increase interest rates...possibly cutting off the new boom.

And from the west what do they have to fear? Well, there's that business in Europe. You know, Greece and all. The PIIGS - Portugal, Italy, Ireland, Greece and Spain... Europe's peripheral countries are in trouble. Lenders fret that they might be forced to default on their debt. So, they want higher interest rates. This, of course, just makes state finances worse...pushing the PIIGS closer to default.

The PIIGS owe $2 trillion, which might need to be restructured. Yes, dear reader, the sovereign debt problem is a big one - much bigger than Bear Stearns, Lehman Bros. and AIG. But the biggest porker of all - the USA - has fives times as much sovereign debt as all the PIIGS put together.

It won't take investors long to figure out that there isn't a whole lot of difference between Greece's finances and those of the US. Each has about the same amount of debt and the same size deficit, relative to GDP. The big difference is that the US ultimately controls the currency in which its debt is calibrated. Greece does not. Neither does California.

Both California and Greece borrow long-term at about the same rate...around 6%. Lenders know that when their backs are to the wall, both governments will have only two choices, not three. They can cut spending. Or, they can default. What they can't do is wiggle out of their obligations by inflating their currencies.

Jean Claude Trichet has already made that clear:

"...belonging to the euro area, you...have an easy means of financing your current account deficit. You share a currency that is credible, so that you have a quality of financing that corresponds to that of a credible currency."

He went on to say that Greece contributes only about 3% to the total output of the euro-zone. If push comes to shove, Greece will be pushed out rather than allowed to weaken the euro.

Then, Mr. Trichet made an odious comparison. California is a much bigger part of the US economy than Greece is of the euro economy. In fact, it is more than four times as large. Will the US come to California's aid? Mr. Trichet didn't say.

It is possible, of course, that Mr. Obama will say to the Golden State what Gerald Ford said to the Big Apple. In 1975, New York City's back was to the wall. It appealed to Washington for help. "Ford to City: Drop Dead," was the famous headline in the New York Daily News, reporting the president's response.

New Yorkers were incensed. Later, they realized that by vowing to veto a bailout President Ford had done them a great favor; he forced New York to clean up its act. The city went on to its greatest years. Likewise, the feds would be doing all of us a favor by letting failure fail with dignity.

Will Obama help California mend its ways? Or will he turn it into a zombie state?

Bill Bonner
for The Daily Reckoning Australia

• It’s the Little Economies that Have Trouble
• The Debt Collection Business Booms
• Trichet Should Tell Greeks to Drop Dead
• Australian Dollar Set to Grow for the Remainder of 2008
• European Governments of the Eurozone are Separately Responsible for Their Euro-debt

What happened to global warming? This report from colleague Chris Hunter in Ireland, where we have our Family Office:

"Ireland is under snow - lots of it. The media have dubbed it the 'Big Chill.' It hasn't been colder since 1962. I stupidly tried to drive to a nearby village yesterday evening in said snow and got my car stuck in a ditch.

"I'm now holed up in a friend's house waiting for an opportunity to rescue my car and get back to the office..."

Fierce storms are approaching the financial markets too. But almost nobody sees them coming.

"We're now in a period of wealth destruction," says George Soros. "It is going to be very hard to preserve your wealth in these circumstances."

It is astonishing. But after the biggest financial crisis in the history of the planet, few people are concerned about wealth destruction; like James Cramer, they're just interested in "getting back to even."

At least, that's the sense we get by talking to people in America...and from looking inside our own feelings. Are we worried? Yes...when we think about it. That is, we know we SHOULD be worried. But we don't feel particularly worried.

We recall how we felt after Lehman Bros. went broke. We checked our bank balances. We looked at our portfolios. We counted our gold. We took inventory in our wine cellar, wondering if we had enough liquid assets to survive a long, deep depression in the style to which we wanted to remain accustomed.

We ranted and raved. Household and business spending were curtailed. Trips were cancelled. We ordered the children to stop getting pizzas delivered to the door; henceforth, if they wanted a pizza they'd have to walk down the street and get it themselves.

We deliberately tried to create an atmosphere of alarm. We knew trouble was coming...and we wanted to prepare everyone around us. It was a "WorldWide Financial Meltdown," we told everyone. A WWFM, for short. This provided a useful shorthand.

'Hey Dad, I need a new coat...my old one's too small,' Edward said last December.

'Forget it! Remember the WWFM!'

Now, it's more than a year later. Edward went out and bought one of those fashionable "Canada" brand jackets last month. We told him he could...and then gasped when we found out how expensive they are.

The fear has receded, not just from the economy...but from our own souls. We no longer feel it. Afraid? Why? We already faced death...and survived. Everything will be all right now. We count the months until we are even again.

And yet...when we look at the reasons for the fear last fall - they're still there.

The stock market has not been corrected. It could easily get cut in half in the next six months. (We're leaving our 'Crash Alert' flying over the building with the gold balls...until stocks reach bargain prices.)

The bond market could crash any time. The US is borrowing more money than ever before - trillions more. With such a huge increase in supply, demand...and prices...it should crack, sooner or later. Higher bond yields would send the whole economy into a much deeper depression.

Even our gold holdings could lose 20%-30% of their value. And gold stocks? They could get killed in the next stock market downswing.

Despite a truly monumental (albeit imbecilic) effort to revive the economy...the latest figures show the weakest post-recession recovery ever. Jobs are missing. Consumer credit is shrinking. Inflation is going negative. There is no real recovery...it's a mirage created by government spending.

Monetary policy is useless (banks won't lend; consumers won't borrow). And fiscal policy, while apparently more effective, destroys wealth; it doesn't add to it.

The more the government increases spending, to offset the correction, the more the economy becomes addicted to it. It's like trying to cure an alcoholic by introducing him to heroin. Take away the government spending - as Japan tried to do - and the economy collapses into a deeper depression. Not only that, but the budget deficit actually grows!

In other words, the feds spend money they don't have trying to fight a correction. This creates huge budget deficits, but it makes it look like the economy is recovering. So they slack off. Then, they discover that their fiscal stimulus didn't really create any genuine economic activity. Take away the fiscal stimulus and the economy collapses again...reducing tax receipts and widening the deficit. In effect, the cure became a disease of its own! Now they can't cut government spending. The economy depends on it. Instead, they're locked into a debt spiral...more and more deficits...higher and higher debt...down, down, down, until...

..until the whole thing finally crashes.

Japan faced this problem in the '90s. It eased off its stimulus program...and the economy collapsed. Now, it's become hooked on government spending. Where does it lead? We repeat this prescient note from The Telegraph, which we sent you yesterday:

"This is the year when Tokyo finds it can no longer borrow at 1pc from a captive bond market, and when it must foot the bill for all those fiscal packages that seemed such a good idea at the time...

"Once the dam breaks, debt service costs will tear the budget to pieces. The Bank of Japan will pull the emergency lever on QE [quantitative easing...aka 'printing money']. The country will flip from deflation to incipient hyperinflation..."

But we're not worried. Somehow it will all work out. Americans are still trying to get even. They still believe that the stock market will recover - fully. They still think the Fed is in control...and that our economists know what they are doing. They are delusional, in other words.

Today is a big day for economists. The feds are supposed to tell us if the economy is still losing jobs...or not. They think December was a good month for employment in the US, and they believe they can prove it. If jobs are stable...or even rising...they will announce a great victory.

But whatever numbers come out, Daily Reckoning readers are advised to ignore them. The Labor Department treats its raw data like Baltimore treats raw sewage. It gets pumped up and churned out...and finally, dumped in the river. By the time it comes out, it doesn't smell so bad.

Here's John Crudele in The New York Post with more details...

"First, there will be invisible seasonal adjustments that will skew the figures.

"Since so few jobs were created in December 2008, the Labor Department's computers were probably expecting the same pattern in this latest Christmas season, meaning that few jobs would be created in 2009 as well.

"So even a small increase in jobs last month compared with December 2008 could be magnified in the accounting into something much bigger.

"And that one isn't even the biggie.

"Friday's figure will also be altered by job growth that the Labor Department is pretending has occurred at newly formed companies. The department calls this its birth/death model and by itself this assumption could be more destructive to the US economy than any terrorist attack could ever be.

"For instance, in December 2008 the Labor Department assumed that 60,000 jobs were created by infant companies that couldn't be surveyed, and weren't contacted, by its workers. Without that assumption, the job losses that month would have been worse than the almost incomprehensible figure of 681,000 that was publicly announced.

"The trouble is, those extra 60,000 jobs don't exist.

"The birth/death model since this past April has added an additional 900,000 jobs. And eventually those 900,000 jobs will probably also have to be extracted from the Labor Department's count.

"But it gets worse.

"Remember, it's called the birth/death model. And while the Labor Department adds jobs 11 months a year, it also subtracts jobs, the 'death' part, during one month.

"And that month is January.

"In January 2009, a stunning 356,000 jobs were removed from the overall count because of the birth/death model. That resulted in a much larger- than-expected loss of jobs during the first month of the Obama administration. The panic was palpable.

"Without a change, the Labor Department will subtract a similarly large number of jobs this January. And when that month's labor figures are reported on Feb. 4, watch out! The stock market will not like this. "

Bill Bonner
for The Daily Reckoning Australia

• Job Losses From Private-sector Rose Since Beginning of Recession
• U.S. Government Hiding True Unemployment Rate in Statistics
• Don’t Bet on a Recovery
• Lower Bond Yields by Any Means Necessary
• Credit Default Swap: Buying Insurance Against Default in Your Bonds

ON 18 SEPTEMBER 2008 - three days after the collapse of Lehman Bros. - US regulator the Securities & Exchange Commission issued what it called an "emergency order" banning the short-selling of 799 financial stocks.

The order, running for 10 business days, came amid of flurry of short-selling restrictions - first demanding that all stock sold short be delivered to the buyer within 3 days, and then that all current open shorts be closed - made under emergency powers granted by the Depression-era Securities Exchange Act of 1934. It came two months after a separate ban on selling short the stock of Lehmans, Fannie Mae, Freddie Mac and 16 other securities firms.

Some success that proved.

"Unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions, unrelated to true price valuation," said SEC chairman Christopher Cox the next day, announcing the new defense of 799 ailing firms' capital base.

"The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets."

News that "market manipulation" was over, along with the forced rush to cover existing shorts, saw the sector jump more than 12% higher in one day as priced by the SPDR Financial Select ETF (XLF). You can see that day's jump in trading volume on the chart below, too.

Without the selfish hedge-fund black hats knocking perfectly sound companies lower, America's finest financial firms could get back to making money rather than hemorrhaging risk capital at the NYSE. Or so the logic (or what passed for logic) ran in Washington.

Yet by the time the Sept. order expired at midnight 2nd October, US financial stocks were back where they'd started before the SEC invoked this power. Two days later, they'd sunk to a fresh six-year low. By the end of Oct. they had fallen a further 21%...and were on their way to a loss of more than two-thirds by the following March - and all this with the anti "naked shorts" regulations still firmly in place.

Glancing back from the comparative calm of late autumn 2009, you might think that short-selling was perhaps contained by the order. The plunge was worse after it lapsed, after all, and the market didn't quite get to zero. But even when extended for four months or more elsewhere, similar bans around the world met with similar success.

The UK's Financial Services Authority lifted its short-selling ban - begun the same day as the SEC's order (and just as the Bank of England was pumping £61.6 billion, then $110bn, into the two largest failed banks) - on 16th Jan. 2009, by which time Britain's banking stocks had lost a further 61% of their value. Greece didn't get round to lifting its short-selling ban until 1st June 2009. Nor did South Korea. Australia was a week earlier, but by then the ASX-200 Financial index stood lower by one-fifth from just after the Lehman's collapse, albeit turning higher from the 34% drop to March '09.

The financial authorities in Vietnam, meantime, have been facing a different kind of problem - and chosen to meet it with a different kind of exchange control, too. The results to date, however, look equally equivocal.

Vietnamese consumers, suffering cost-price inflation of 25% by June 2008, were exchanging capital in the form of Dong into gold. Indeed, the world's largest market for investment gold bars outside the West during the first quarter of last year, Vietnam had already imported 60 tonnes of gold - paid for by a net outflow of $1.8 billion - during the first five months of the year. That was twice the pace-by-volume set in early 2007.

So the communist authorities, rather than addressing the plight of the Dong - which had already slipped further in the black market, despite an outright devaluation of the regime's US-Dollar peg two weeks before - opted instead to ban gold imports altogether. Because if buying gold was how people were choosing to defend themselves, then just like US funds short-selling the lamest financial stocks, they must in fact be part of the problem. Right?

Doubling import duties on gold to 1% in May 2008 hadn't helped. An outright ban remained to be tried. But the upshot? Seventeen months later - and with domestic gold owners blamed for profiteering as new would-be buyers sought refuge in gold - the ban was lifted at last. By early Nov. '09, however, Vietnamese gold prices stood some 42% higher, thanks both to the rising international price but more especially to the lack of inflows of metal.

The Dong, in short, had lost ground to the Dollar but sunk versus gold. And all along, Vietnam's appetite for new metal was part-sated regardless. The GFMS consultancy reckons more than 30% of gold imports to Thailand found their way across the border during the second-half of 2008.

Even with new gold now flowing into the country, gold still trades above 27.58 million Viet Dong per tael - south-east Asia's variable "street dealing" unit, equal to 1.2 troy ounces in Vietnam. That puts the domestic cost of gold roughly $52 an ounce higher than international spot pricing according to figures from Vietnam Gold Market News...which is down from the $150 premium achieved just before Hanoi relented, but still a marked premium for Vietnam's capitalist-communist citizenry.

"Taking advantage of unstable international gold prices and peoples' concern that prices will rise further, local speculators have [still] pushed prices to a very high level," as central bank governor Nguyen Van Giau said when he lifted the import restriction two weeks ago.

Aimed at "stabilizing the gold market and preventing speculation", the central bank's statement in fact helped send the Vietnamese Dong to a 16-month low on the currency market, down 6.4% on 1-year forward contracts, thereby pushing local gold prices higher again!

Since then, and with the currency still falling, Hanoi's foreign currency reserves have now shrunk by one quarter to $16.5 billion from the start of this year. Fighting to defend its Dollar-peg in the market - by buying up Dong with overseas money - the government admitted that it's target trade deficit for 2009 was already seven-eighths spent with another two months to go. So this week, it opted to raise interest rates - the obvious route to stemming a currency run - but not until December. It's also devalued the Dong yet again, down 5.44% from Thursday morning per Dollar, but still only playing catch-up with the black market exchange rate once again.

Commercial banks are meantime banned from trading in Dollars if the Dong moves 3% or more away from its target exchange rate. Quotas also remain in place for importing gold, with licenses for 10 tonnes issued this week according to Reuters. Some 6.8 tonnes of bullion have already been imported, the state TV station reported today, since the import ban was lifted a fortnight ago.

"These imports will have an impact on the local gold market," reckons Van Giau. But then he also says the latest Dong devaluation and interest-rate hike - from 7% to 8% -represent a "solution to strongly intervene." Whereas HSBC's chief Asian economist, Robert Prior-Wandesforde, sees Vietnamese interest rates rising further to 11% by year-end, while GFMS analyst Rhona O'Connell notes how "The change in the Vietnamese government's policy over gold imports [in fact] illustrates that demand remains strong at grass roots level."

Oh sure - government policy helped stem the last global bull market in gold. Raising the margin requirement on US gold futures took the heat out of the metal's parabolic surge of late-Jan. 1980, coinciding with what then proved a 28-year record at $850 an ounce. But unlike blaming short-sellers for the collapse of the banks, it was only by addressing the true fundamentals that the authorities could hope to reverse the flight into gold.

Double-digit returns offered to cash-in-the-bank killed the need to defend savings with metal. And this time around, not even import bans could take the heat out of Vietnamese hoarding.

Adrian Ash
for The Daily Reckoning Australia

• Vietnam Stock Exchange Plunges, Investors Trading in What Little Dongs They Have
• What is Short Selling?
• Vietnam: The Next Bubble in the Emerging Markets
• The Practice of Naked Short-selling
• Short Selling Ban May Kick Off Market Liquidation

Now, the question we must ask ourselves is an old one: is this the final, blow-out phase of the gold bull market that began 10 years ago? Or is it a trap...intended to catch the Johnny-come-latelies in the gold market? Of course, we don't know any more than any other human being knows. But we've been watching Mr. Market for a long time. And we've come to the conclusion that he's an SOB. Trouble is, you never know exactly what kind of an SOB he's going to be.

Is he going to lure investors into the gold market and give them a good whack? Or, is he going to drive the price of gold all the way to $3,000...and leave us behind?

The old-timers, the scarred and battered confrere of gold bugs, in which your editor humbly confesses membership, are a bit skeptical of this latest run-up in gold prices. We bought gold years ago. Heck, we bought so many gold coins so long ago that we've forgotten where we buried them. So, we wouldn't mind seeing gold race right up to its rendezvous with monetary destiny - without stopping for red lights or little old ladies in the crosswalks.

Trouble is, we don't think the world is ready for it. What do we mean by that?

We were hoping you wouldn't ask. It's complicated and confusing. In many ways, it's more of a feeling...an instinct...and a hunch...than a hard analysis. But here goes:

Look, here's the hero of the financial crisis, David Einhorn. In 2007, he figured out that the banks were going to get killed on their mortgage debt. He shorted them - particularly Lehman Bros. He made a fortune for himself and his investors.

Well, what's he doing now? Guess. He's buying gold:

David Einhorn, quoted in MarketWatch, said that given the present situation gold was the bet he felt most confident to make:

"If the chairman of the Fed is determined to debase the currency, he will succeed," Einhorn said. "Our instinct is that gold will do well either way: deflation will lead to further steps to debase the currency, while inflation speaks for itself."

In other words, gold is a one-way bet. But wait. It's not like Mr. Market to offer investors one-way bets. There's usually more to the story. And the twist is probably this:

Deflation will surely lead to more steps to debase the currency, but those steps don't necessarily or automatically take the feds where they want to go. We have no doubt that the Fed chairman is determined. What we doubt is that he is capable. We doubt, too that a 3.5% downturn over 24 months corrected 30 years of credit excess. There's still Hell to pay. It means another big takedown in the stock markets...crashes in China and emerging markets...and collapsing commodity prices. Investors won't like it.

Will they turn to gold for safety? Or to the dollar? A year ago, they dropped gold and ran to the dollar. Will they do the same this time? We don't know, but we doubt that SOB, Mr. Market, will make it easy for us, either way.

Bill Bonner
for The Daily Reckoning Australia

• Gold and the Euro Just Hooked Up Together Again
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"The future will be a total disaster, with a collapse of our capitalistic system as we know it today, wars, massive government debt defaults and the impoverishment of large segments of Western society," he writes.

"We have a money-printer at the Fed," he continues, "which guarantees runaway inflation, wholesale debasement of the dollar, and a major lowering of living standards for most Americans and many Europeans as well.

"Meanwhile, Paul Volcker says that China's rise merely 'highlights the relative decline of the US.'"

So there you have it: China on the way up, America on the way down.

That's the drama that we're watching every day, here at The Daily Reckoning. In our view, the peak of US wealth and power probably came during the period between the fall of the Berlin Wall and the fall of Lehman Bros. But there are probably a lot more shoes to drop before people are fully aware of what is going on.

The way we see it, almost the entire 20th century was a mistake...a dead end.

Europeans were clearly on top of the world when the century began. Then, after WWI the Europeans in America took the lead role. But WWI shook their faith in their evolving political order. Not long after, the German hyperinflation and the Great Depression shook their faith in their economic and financial order. This left a huge vacuum, which was soon filled by ruthless adventurers and ideological schemers. Much of the rest of the century...from '39 to '89...was spent in hot wars and cold wars against these Bolsheviks, Fascists, Stalinists and Maoists.

In the end, the more reasonable and consensual societies of the West won the battle. But they, too, were transformed by 50 years of war and nearly a century of bad ideas.

"Whoever fights monsters should see to it that in the process he does not become a monster. When you look into the abyss, the abyss also looks into you," Nietzsche warned.

Looking into the abyss created by Mussolini, Hitler, Tojo, Pol Pot, and the rest, Western societies decided both to fight them...and to join them. Tax rates soared. Regulations multiplied. University professors taught socialism, Freudianism, modernism, cubism, feminism, racism...and every other 'ism' they could think of. Parents spent good money to spend their children to universities that turned them into mush-heads.

And - perhaps most ominous - in the United States of America, the military grew into a greedy, grasping goliath...the very thing Eisenhower had warned against.

Then, there were counter-trends in the '80s...led by Margaret Thatcher in England and Ronald Reagan in the United States. But these were mostly frauds. Top marginal tax rates were rolled back. And there were some cuts in regulatory procedures. But government spending tended to go up anyway. Worse, Ronald Reagan mistook the Soviet Union for a genuine threat and increased military spending even further to combat it.

And now, the United States staggers under the weight of its eternal wars...its imperial illusions...and its everlasting efforts to provide bread and circuses. If it kept its books like a private enterprise, it would be broke. If it were a public corporation, it would be de-listed.

Still, it spends and spends...and there is no stopping the spending. Trillions are spent on wars in Iraq and Afghanistan, for no apparent reason. But who complains? Too much money is at stake. There are too many lobbyists for too many industries and too many special interests involved. Military spending - even in a time when America faces no substantial challengers - cannot be rolled back. Neither can social spending.

Marc Faber is right. There too, there are too many people with too many dogs in this fight. Both military and social spending will continue to expand until the empire is ruined.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

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This week, Ben Bernanke got the nod for another stint as head of the world's most important central bank. Yes, he completely misunderstood the implications of the hugely negative US trade balance, believing that America did the world a favor by spending its "global saving glut." And, yes, he missed the approach of the biggest financial disaster in three generations. Then, when it arrived, he mistook it for a routine recession, until finally, panicked by the collapse of Lehman Bros., he insisted that Congress pass a $750 billion spending bill - or "we may not have an economy on Monday."

But except for things that really matter, he's been a pretty good Fed chief. Besides, he has the right credentials. He was a professor of economics at Princeton and holds a Ph.D. from MIT - just like the most recent Nobel Prize winner in economics, Paul Krugman.

The United States has just averted the Second Great Depression, say the papers. "What saved us?" asks Krugman in a recent New York Times editorial. "Big government," is his answer. Specifically, the big government of Ben Bernanke.

But the ghost of Milton Friedman haunts the central bank. Bernanke borrowed a phrase from Friedman, saying he'd even "drop money from helicopters,' if necessary, to prevent deflation. This led to one of the surest trades of the Bubble Era was the so-called on the 'Bernanke Put.' Investors thought they could count on him. Buy stocks. If they went down, Ben Bernanke would make sure you didn't lose. He'd add liquidity until the market bounced back. But the Bernanke Put trade went bad in '07. The market fell. Ben Bernanke added liquidity. But so far, stocks have yet to regain 50% of what they lost. Meanwhile, consumer prices are falling. And yet, he does not drop money from helicopters. Why not?

Few people would have more authority on the subject than the group gathered at the Beverly Hilton in Los Angeles earlier this year. Michael Milken, the Junk Bond King, gathered them thither and picked up the tab for Gary Becker, Myron Scholes, and Roger Myerson...each of their names is preceded by 'Nobel Prize winner.' With that kind of brainpower on hand, you'd think you could come up with a good explanation. But the best they could do was a simple analogy. Gary Becker (Nobel awarded '92) took the Friedman line; he argued that by putting out the little forest fires, the recessions of the '90s and the early '00s, the feds inadvertently created the conditions for an even greater conflagration. Instead of burning off the underbrush, the tinder built up until a huge blaze was inevitable. And in a speech honoring Friedman, Bernanke accepted Friedman's criticism of the Fed in the '30s. Yes, Bernanke admitted, the Fed made mistakes; but we won't do it again, he said. The burden of today's rumination is that he was wrong; he will do it again.

"Inflation is always and everywhere a monetary phenomenon," said Friedman. But deflation doesn't seem to be a monetary phenomenon at all. Despite huge inputs of new money from the Fed, prices are still going down. The Fed's balance sheet more than doubled in the last 18 months. It will probably double again - to $4 trillion - before Bernanke's next term is over.

Friedman won a Nobel Prize for his work. And he drew around him a community of scholars that won so many Nobel Prizes they ran out of room in the University of Chicago trophy cabinet. But it only makes you wonder about the Nobel committee. Friedman's acolytes won their prizes for elaborating a series of mathematical proofs for things that were either self-evident or self-evidently absurd. Most of them were later shown to be wrong, irrelevant or misleading. Modern Portfolio Theory, Black-Scholes Option Pricing Model, Dynamic Hedging - the farther afield the scholars went, the more they lost touch with home. The more scientific their work became, the more it resembled alchemy or phrenology.

Friedman's work itself was flawed in the same way. The general principle was correct - that the government that governs the markets least governs best. But when he got into the mechanics of 'monetarism,' he got lost. He believed that if the Fed kept its eye on the money supply; the free market would take care of everything else. But the free market didn't take of everything, at least not as people hoped. Economist Murray Rothbard explained why in 1971. You cannot expect the free market to function perfectly if you leave in the hands of the government the power to control money. Either markets are free or they aren't, was Rothbard's point. If they're not free, you can't blame freedom when they fail.

But free market economists are now blamed for everything. The free- market Chicago boys are out. The MIT crowd is in. And investors are buying the Bernanke Put again, confident that the Fed chief will keep pushing money into the system and stocks will continue rising. But Ben Bernanke, for all his bluster, is a victim of the trade. Everyone knows what he is up to. They can't help but look ahead and see where it leads.

As soon as Bernanke starts his helicopter engines, bond buyers get out their missiles; the Chinese - the biggest single customer for US debt - have warned that they will shoot him down. What can Bernanke do? He is damned if he doesn't. But even more damned if he does. He can't guarantee increases in either CPI or stocks. All he guarantees is that Big Government will play a larger role in the economy...and that Milton Friedman's history of the Great Depression will turn out to be prophecy:

"The Fed was largely responsible for converting what might have been a garden-variety recession... into a major catastrophe..."

Ultimately, Bernanke does what his predecessors at the Fed did in the '30s...and what the Japanese did in the '90s. He hesitates. He makes mistakes.

And he wonders why he took the damned job in the first place.

Until next time,

Bill Bonner
for The Daily Reckoning Australia

• Ben Bernanke Pays Homage to Milton Friedman’s Theory
• Barack Obama and His Nobel Peace Prize
• Krugman Warns That the Run-up in Stocks Can’t Be Justified By the Fundamentals
• Everyone is Getting Tough on Bankers
• Keynesians Believe Governments Have to Manage Economy in Macro-Economic Way

"The value of gold, as the only true 'hard currency,' is coming to the fore, as evidenced by the investment choices of some of the world's most seasoned investors."

- AngloGold Ashanti Ltd. Chief Executive Officer Mark Cutifani

For the first time in a couple of decades, some of America's most successful, big-name investors are buying gold. David Einhorn, the hedge fund manager who predicted the downfall of Lehman Bros., recently bought gold for the first time. And then there is John Paulson, the guy who made billions of dollars by correctly anticipating the housing bust and credit crisis.

Paulson just plunked down $1.3 billion for an 11% stake in AngloGold. He's also got a big position in Kinross Gold.

Peter Munk, the 82-year-old chairman and founder of Barrick Gold, also offers up his own anecdote about gold's broadening appeal. "I have had more phone calls in the past six months than ever before - from people who have $120,000 inherited from grandmother, and from hedge fund managers with millions," he says. "I am not saying George Soros, but people of that caliber have told me they are buying gold."

You no longer have to be a gold bug to think gold will rise in price. In fact, this buying by some of the world's greatest investors may be the leading indicator for a quick 116% climb - to $2,000 per ounce or higher. Give gold the cold stare of a professional handicapper and the odds look very good, indeed.

Why? The biggest reason is that the value of the dollar looks about as brittle as a 90-year-old's hip socket. And if you worry about the value of the dollar - or any paper currency - then gold is a good alternative.

In fact, gold has held up well while most everything else has taken a beating over the last year. On a recent conference call with investors, First Eagle fund manager Abhay Deshpande points out that gold is at a new high in just about every currency apart from the U.S. dollar and Japanese yen. "It has performed its job for everyone in these countries," he says. "It has held its value."

Take a look at the nearby chart and you can see the falloff of the dollar in recent years and the rise of gold.

"But there have always been worries about the value of the dollar," you say. "That's not new." True. What is new is a global financial crisis unlike anything we've seen in the post-World War II era. And that crisis has brought with it serious doubts - the most serious in decades - about the dollar's ability to keep its top perch in the aviary of world currencies. As that doubt increases, gold gathers new fans.

As I write, the headlines are abuzz with China's proposal to replace the dollar as the world's reserve currency. (The U.S. Treasury secretary, in a weak moment, said: "We are quite open to that." He took back those words, but the hammer had already hit the nail.) China and other countries hold a lot of dollars. And they are not too happy to see the U.S. government handing out bills like after dinner mints. America's $2 trillion (and ballooning) annual deficit and ballooning national debt causes them to wonder about the value of all the paper they hold.

They are not the only ones worried, as I noted up top. Many top investors are already buying gold.

It is easy to buy gold today with gold exchange-traded funds (ETFs). They are like mutual funds that hold gold. As investors pile into these ETFs, the ETFs' gold holdings also go up. It's one way to see the dramatic increase in demand for gold in just the last few quarters. (See chart below.)

So we have to ask: At $900 per ounce, are all the fears baked in or are we on some new history-making path?

I have a good friend who advises institutional clients on investing. As he reminds me, the really big money hasn't started buying yet. There are no big pension funds or endowments with significant gold holdings. That could change. If so, the gold price will go wild.

"Gold is a small market," Munk notes. Munk's career spans 60 years and he knows the gold market as well as anyone. Says he:

"Let's say a small percentage of the world's central banks - or simply the United Arab Emirates itself - do not believe President Obama's pledge that he will halve the U.S. deficit by the end of his first term. They shift some of their dollar reserves to gold. It would not take many decisions of this kind to push the price above $2,000 per ounce."

That's how gold gets to $2,000 per ounce - just a bit of doubt turning into action. The mind boggles at what would happen if China decided to hold more gold! Gold could well hit $5,000! As long as President Obama, Fed Chief Bernanke and pals treat the dollar like confetti, gold should continue to gather new fans. And gold stocks should do even better.

Gold stocks are supposed to do especially well as gold rises. But that has not been the case over the last year and a half. Mostly, this was because mining costs were rising as fast as, or faster than, the price of gold - thanks in part to record-high energy prices. But as Deshpande points out: "These things have reversed in recent months as gold stocks became quite cheap relative to the underlying value of the gold in the ground."

The case for gold and gold shares is a nice and clean setup, like one of those toy houses in the window at Macy's on Madison Avenue. The world order will not always hinge around the dollar. Global finance will not always find its center on Wall Street. As Munk pointed out: "Look around Davos this year. So Goldman Sachs cancels its dinner party. In its place, a Kazakh company has a dinner party."

As the dollar goes bust, who knows what will replace it? With gold, you don't have to worry too much about the answer.

Regards,

Chris Mayer
for The Daily Reckoning Australia

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Ten years ago, the New York Federal Reserve Bank called upon Lehman Bros. and a handful of other major players on Wall Street to rescue a high-flying hedge fund. The firms grumped and whined...but they came up with the money, $3.7 billion. The rescue was a success. LTCM's positions were unwound slowly; there was no panic; Wall Street soon went back to doing what it is supposed to do - separating customers from their money.

Long Term Capital Management was run by a couple of Nobel Prize winning economists who believed they could use past financial patterns to model the future - just as if price movements were the same as the weather. If a hurricane had hit Houston twice in the last century, they figured the odds that another hurricane would hit the city at 1 in 50. Likewise, if the price of Lehman stock traded between, say, $10 and $30 during its 158-year history, they figured - grosso modo - that it would stay between $10 and $30.

LTCM went bust when the future turned out to be different from the past. Anyone with his eyes open at the time could have told the Nobel laureates why: weather patterns were independent of human decisions; market patterns are not.

One of the big revelations of the '90s - or was it the '80s? - was that stocks were traditionally, historically under-priced. Compared to bonds, said a popular financial author, stocks were a better deal. Stock buyers earned a premium over bonds for the risk they undertook, he said. But if you held stocks "for the long run," the risk disappeared. Buying stocks seemed like a no-brainer.

Thus did the lumpen investoriat begin pumping money into stocks...cautiously in the beginning of the '90s...and recklessly at the end of the decade. And by the year 2000, the stock market no longer reflected the "random" movement of prices as predicted by the previous hundred years of stock market history; instead, it reflected the recent and remarkable belief that stocks always went up...and that if an investor held long enough the risk disappeared.

From the peak of 2000 'til today, stock market investors have earned nothing for their trouble. In nominal terms, stocks are about where they were 10 years ago. Adjusted for inflation, they are down 25%-80%, depending on how you measure it.

Wall Street made a fortune selling stocks to naive investors. When the stock marked topped out, the financial industry might have gone back to sleep. Instead, it got a double dose of caffeine. The Greenspan Fed cut rates in 2001-2002 while the Bush administration boosted spending and cut taxes. All of a sudden, every hand on Wall Street turned to pumping out credit - derivatives, SIVs, CDOs, MBS. They didn't really have to invent any new theories, they merely recycled the same numbskull ideas that sank LTCM - basically, that you could eliminate risk by modeling historic price movements. If Lehman Bros., for example, had never failed in more than a century and a half - the odds that it would fail this year were so close to zero as to be not worth discussing.

But...

"Lehman lurching closer to liquidation," says the front page of today's International Herald Tribune.

Now, it's Lehman that is failing. And no consortium of Wall Street banks is willing, or able, to bail it out. Lehman has some $80 billion of dubious credits. These were the products of its own - and many other - whiz kid financial engineers. Lehman hired some of the best talent on Wall Street. It has some of the world's top financial mathematicians on its payroll. It could compute the risk of loss down to 3...4...heck...as many decimal places as you like. But it could do so only as LTCM did - based on past history.

As we explained, once investors came to consider stocks as a riskless way to get rich, they bid up prices to the point where they were all risk...and no reward. And when their models told them that they could make money by lending money to people who couldn't pay it back, practically every loan they made took them closer to bankruptcy.

*** The financial industry gained more than any other from the big credit expansion. It makes sense that it should be the industry that suffers most when credit goes the other way.

In that regard, history is a good indicator of what to expect. You can guess about the very broad patterns of the future, based on what you know about the past...and of your fellow man. We know, for example, that investors tend to go from one extreme to another. At once, they are afraid of credit...and then they feel as though credit were their best friend in the world. And they go from feeling very optimistic about the future...to feeling very pessimistic. These feelings have market consequences. When they are upbeat and sans soucis they are willing to lend at very low rates of interest, for example. Why not? They're sure they'll get their money back. And when they are feeling lucky, they'll invest in wild-eyed schemes and half-baked projects too. Everything is going their way; so why not?

But then, the mood changes. The schemes fail. Money is lost. And gradually people come to believe that the future holds more bad days than good ones. Yields rise - as they ask for higher rates of interest before lending money. Not only are they afraid that they may not get their money back, they're also afraid that the money they get back may not be worth as much as the money they lent out. At the peak of the yields cycle in '82, for example, investors wanted 14% interest before they'd lend money even to the U.S. government!

When they get gloomy, they want higher cash dividends from their stocks too. Gone are the days when they believed they could just buy stocks and get rich. They come to believe that if a stock is not paying its way - with dividends each year - out it goes. During the Great Depression, for example, stock market investors sold stocks down to such a low level that they paid an average dividend of more than 10%.

We're still a long way from there. The yield on the 10-year T-note is above 3.7% - but still about 200 basis points below the level of consumer price inflation. Which is to say, real yields on Treasury paper are negative. Still, they're better than dividend yields, which average only about 2.5%. Investors still believe that their stocks will go up, so they're willing to accept dividend yields of less than half the current CPI.

But we're headed in the right direction. Lehman is going bust. AIG is struggling...hopping for a $40 bailout from the government. Houses in California are down 30%...and still sinking.

Alan Greenspan, who bears more responsibility for the present state of financial affairs than anyone, says this may be a "once in a century," event. This time he could be right...

More tomorrow...

Bill Bonner
The Daily Reckoning Australia

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