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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My interest in Andy was due to the fact that he has been singularly successful in pretty much all aspects of the real estate market, including financing and developing large projects - such as shopping centers, apartment communities, office buildings, and warehouses - from one end of the country to the other. His expertise has also allowed him to build an impressive business providing assistance to large financial institutions that need help in dealing with problem commercial real estate loans. As you might suspect, business is booming.

Back in 2007, however, what most intrigued me about Andy was that he had been almost alone among his peer group in foreseeing the coming end of the real estate bubble, and in liquidating essentially all of his considerable portfolio of projects near the top. There are people who think they know what's going on, and those who actually know - Andy very much belongs in the latter category.

In fact, he initially refused to speak at our event, only agreeing very reluctantly after I had hounded him for several months. The reason for his refusal, I later found out, was that he had spoken at several industry events before the real estate collapse and had been all but booed off the stage for his dire outlook.

So far, Andy's real estate forecasts continue to come true. As you'll read in the following excerpt from my latest interview with Andy, who now spends considerable time each day helping the nation's biggest banks cope with growing stacks of problem loans, he remains deeply concerned about the outlook for real estate.

GALLAND: No one has been more right on the housing market in recent years. So, what's coming next? Some of the housing numbers in the last few months look a little less ugly. Could housing be getting ready to get well?

MILLER: I don't think so.

For all intents and purposes, the United States home mortgage market has been nationalized without anybody noticing. Last September, reportedly over 95% of all new loans for single-family homes in the US were made with federal assistance, either through Fannie Mae and the implied guarantee, or Freddie Mac, or through the FHA.

If it's true that most of the financing in the single-family home market is being facilitated by government guarantees, that should make everybody very, very concerned. If government support goes away, and it will go away, where will that leave the home market? It leaves you with a catastrophe, because private lenders for single-family homes are nervous. Lenders that are still lending are reverting to 75% to 80% loan to value. But that doesn't help a homeowner whose property is worth less than the mortgage. So when the supply of government- facilitated loans dries up, it's going to put the home market in a very, very bad place.

Why am I so certain that the federal government will have to cut back on its lending? Because most of the financing is done via the bond market, through Ginnie Mae or other government agencies. And the numbers are so big that eventually the bond market is going to gag on the government-sponsored paper.

The public doesn't have any idea of the scale of the guarantees the government is taking on through Fannie, Freddie, and FHA. It's huge. If people understood what the federal government has done and subjected the taxpayers to, there would be a public outrage. But you can't get people to focus on it, and it's very esoteric, it's very hard to understand. But it's not something the bond market won't notice. The government can't keep doing what it has been doing to support mortgage lending without pushing interest rates way up.

Refinancings of single-family homes are very interest-rate sensitive. Consumers have their backs against the wall. They have too much debt. Refinancing their maturing mortgages or their adjustable-rate mortgages is very problematic if rates go up, but that's exactly where they're headed. So anyone who's comforted by current statistics on single- family homes should look beyond the data and into the dynamics of the market. What they'll find is very alarming.

GALLAND: On that topic, recent data I saw was that something like 24% of the loans FHA backed in 2007 are now in default, and for those generated in 2008, 20% are in default, and the FHA is out of money.

MILLER: Fannie Mae had a $19 billion loss for the third quarter of 2009, and they are now drawing on their facility with the US Treasury. We have all forgotten that Fannie and Freddie are still being operated under a federal conservatorship. On Christmas Eve, the agency announced that it was going to remove all the caps on the agencies.

GALLAND: So what about commercial real estate?

MILLER: When I saw what was happening in the housing market, I liquidated all my multi-family apartments, shopping centers, and office buildings. I liquidated all my loan portfolios, and I'm happy I did.

It occurred to me in 2005 and 2006 that the commercial world had to follow suit. Why? Because it's a normal progression. Obviously, when single-family homes decline in value, multi-family apartments decline in value. And when consumers hit the wall with spending and debt, that's going to have an impact on retailers that pay for commercial space.

Furthermore, the financing for retail properties had gotten ludicrous. The conduits were making loans that they advertised as 80% of property value when they originated them, but in reality the loan-to-value ratios were well over 100%. And I say that to you with absolute, categorical certainty, because I was a seller and nobody knew the value of the properties that I was selling better than I did. I had operated some of them for 20 years, so I knew exactly what they were bringing in. I knew what the operating expenses were, and I knew what the cap rates were. And, you know, the underwriting on the loan side and the purchasing side of these assets was completely insane. It was ludicrous. It did not reflect at all what the conduits thought they were doing. They were valuing the properties way too aggressively.
I became very bearish about the commercial business starting in late '05.

GALLAND: Beyond the obvious, that the real estate market has taken pretty significant hits and some banks have been dragged under by their bad loans, what has really changed in real estate since the crash?

MILLER: I think the first thing that changed was that people learned that prices don't go up forever. Lenders also saw that underwriting guidelines for commercial real estate loans, especially in the securitization markets, were erroneous. They realized that some of their properties had been financed too aggressively, but still, I don't think even at the fall of Lehman, anybody was predicting a wholesale collapse in commercial real estate.

But they did see they should be more circumspect with loan underwritings. In fact, after the fall of Lehman, they completely stopped lending. I think they realized we had been living in Fantasyland for 10 years. And that was the first change - a mental adjustment from Alice in Wonderland to reality.

Today it's clear that commercial properties are not performing and that values have gone down, although I've got to tell you, the denial is still widespread, particularly in the United States and on the part of lenders sitting on and servicing all these real estate portfolios. People still do not understand how grave this is.

To be continued...

David Galland
for The Daily Reckoning Australia

• An Insider’s View of the Real Estate Train Wreck, Part II
• Commercial Real Estate May Be the Next to Fall
• REIT Investors Grown Complacent About Risks in Commercial Real Estate Market
• How Did Australia Get Caught Up Losing Money in Commercial U.S. Real Estate?
• Hidden Inventory of Unsold Houses Will Depress Housing Prices

Hold your horses, dear reader. We'll have to wait to find out.

The papers attributed the big upward thrust in share prices to news from Europe. The specific fact that caused the swing to profit had to do with Jean-Claude Trichet's travel plans. He was in Australia for one meeting; now he's coming back to Europe early so he can partake of another.

What has caused him to call his travel agent is a problem centered in Greece. The Greeks are in a jam. They spent too much money in the bubble years. Then, they saw their tax revenues disappear in the bust.

Sound familiar? It should, because the same could be said of most of the US states...and most of the world's countries, emerging markets excepted. They all spend too much. Almost all run deficits. And almost all their deficits are getting bigger and bigger.

So far, the big economies don't have a problem. Lenders think they are good for the money. Almost miraculously...or supernaturally...the USA - the world's biggest borrower - is able to obtain financing for 10 years at less than 4% interest. Since the official inflation rate is 2.7%, that means lenders give up their money for a real rate of return of just a little over 1%.

It's the little economies that have trouble. They don't have printing presses of their own. Like California or New York, ultimately, they have to balance their budgets. They can't inflate their way out of trouble. So, when their backs are to the wall they either get tough and cut expenses rudely. Or they go broke...default...and then have the cuts forced upon them.

The focus of this week's discussion is the PIIGS - Portugal, Ireland, Italy, Greece and Spain. Together they've got about $2 trillion worth of debt. And lenders are making it more expensive for them to borrow more. If this continues, they'll default. And then, say the financial authorities, terrible calamities will happen. The whole European financial system could come falling down. It would be the end of the world as we have known it.

Does this sound familiar too? It should. It's the same scare tactic used after Lehman was allowed to go under. AIG had to be saved. And Fannie and Freddie. And GM.

Now, that lame argument is probably going to lead to the bailout of Greece...and by extension, all the other insolvent nations along the periphery of Europe. The debts will be collectivized...just like those of Fannie and Freddie. Instead of being allowed to fail on their own merits, in other words, European nations are locking arms...they are all going to fail together!

Germany's politicians are already talking about a program of support in a "broad sense" for Greece and other problem economies. Soon, in Europe, the English word 'bailout' will be as common as "hamburger" or "coke."

Bill Bonner
for The Daily Reckoning Australia

• Fannie and Freddie are Finito
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We've come to Paris where the family is gathering for Christmas. It has been snowing off and on for the last four days. Yesterday, the snow turned to rain and melted on the ground. Still, the streets glisten, reflecting holiday lights and decorations. By 4 PM it is already getting dark and shoppers rush home with the treasures. By 6 PM the cafes are full of people enjoying drinks together...saying farewell to each other for the holidays...catching up...flirting...even discussing business deals.

We warn readers that we lost our reading glasses. Dear Readers will probably notice more errors than usual!

But reading glasses or no...the reckoning must go on.

Nothing much happened in the markets on Friday. So, we'll stop to think a bit about what has happened this year...and this decade.

You'll recall, of course, our Trade of the Decade - buy gold on dips...sell stocks on rallies. Well, we've been very happy with it. But the decade is coming to an end. It's time to thinking about the NEXT decade.

You'll also recall that as gold went up, we became more and more concerned.

When Lehman went down, it seemed obvious that the feds were going to do the wrong thing. We were right. They did. They put up trillions of dollars to 'rescue' the economy. Since we knew the 'rescue' wouldn't work, we guessed that they would continue pumping in money they didn't have in order to keep trying to do what couldn't be done. Under cover of an 'emergency' they were able to siphon off billions of dollars for their friends on Wall Street and for their pet boondoggles. And the voters couldn't complain...at least they were 'doing something' to fix the economy! This led to a very simple observation - eventually inflation (and gold) would go up even more. Because the quantity of money would increase faster than the goods and services that it could buy.

What bothered us here at The Daily Reckoning was that this analysis was too easy and too obvious. What's more, it was an analysis that was widely shared. We don't like it when our points of view become fashionable. And we don't like it when the "story" is too easy to tell and too easy to understand. When you have a storyline that everyone picks up, it almost always turns out to be wrong.

Then, the smart money began buying gold. John Paulsen made a fortune in the '07-'08 period by correctly understanding the bubble in the financial sector and betting against it. A few months ago, he announced his next big bet: gold. He explained that gold was a 'can't lose' investment. If the economy recovered, inflation would come back and push gold up. If the economy didn't recover, the feds would continue pushing money and credit into the system, making the eventual inflation worse than ever.

John Williams came to a similar conclusion. He noted that the recovery wasn't working...and that the feds had no choice but to continue piling up inflationary tinder. When the spark finally reaches it, he says, the result won't be inflation, but hyperinflation of the blazing sort.

We don't disagree. The logic seems right to us. That is what OUGHT to happen. But what bothers us is that Mr. Market is a contrary ol' coot. He always does what he ought to do. But he rarely does it when and how you expect.

What is he up to now? Darned if we know. The dollar is going up. Is it just a bounce? Or is it a trend?

What would be the most surprising and most mischievous thing Mr. Market could do? Make the dollar more expensive!

It would undermine hopes for an export-led recovery in the US (American made goods would be less competitive...)

It would whack the carry-trade speculators hard. They borrowed cheap dollars. Now they'll have to pay back expensive ones.

It would encourage people to save dollars rather than spend them - thus undermining a consumer-led recovery too.

It would also drop the price of gold - temporarily - shaking off the fair-weather gold buyers in advance of the next phase of the bull market.

So, ask yourself, dear reader... If you were as ornery as Mr. Market...what would you do?

Bill Bonner
for The Daily Reckoning Australia

• Dumb Money Eyes Stock Market While Smart Money Watches Economy
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Meanwhile, our colleagues over at The 5-Minute Forecast argue that the stock market should never have been rallying in the first place. The economy still stinks, they say, and it is showing no signs of recovering. In fact, a close look at the housing market tells you all you need to know about the economy...and the news is not good.

Jay Shartsis, the mind behind the Shartsis Option Alert in New York observes:

The always-intriguing "Stock Cycles Forecast" is looking for an important top right in here. This bearish outlook stems from a quirky collection of indicators called "time and price squareouts." For example:

1) The big S & P low in October of 2002 was 769. If one adds 769 days to the grand top of Oct 11, 2007, it comes out to Nov 18, 2009.

2) Nov 18, 2009 is a "natural square" of the crash of 1929.

3) The Oct 2002 low of 769 on the S&P 500, converted to months is 25 and due west from 25 on the Gann Square of Nine points to an S&P target of 1,104. We are there.

4) We are 85 months from the low recorded on Oct 10, 2002 and due West from 85 on the Gann Square is 1,105, which coincides with the same S&P 500 target.

5) The low last March on the S&P 500 was 666. If we subtract that in days from the recent peak of 1,102, it equals 666 days, which would bring us back to the date of the Lehman bankruptcy - the event that started the crash.

I know all this sounds very wacky and mystical, but Jenkins (the editor of Stock Cycles) has had some very good calls with this methodology in the past.

Another much less mystical indicator is the VIX Index of option volatilities - aka, the Fear Gauge. For starters, the VIX is currently sitting at its lowest levels since just before the stock market crash of one year ago. That's a bearish indicator all by itself. But there's more to the story. The January VIX futures contract is trading at a steep $4 premium to the spot VIX. Normally, a large premium in the near-term futures contracts relative to the spot VIX price would portend an imminent stock market selloff. The opposite is also true.

Thus, three weeks ago, as the S&P was hitting its recent low of 1,029, the VIX futures had a discount of $3 versus spot. Stocks promptly rallied. But today, we find the opposite configuration, which is quite bearish indeed.

A selloff is not guaranteed in here, but it is becoming an increasingly likely possibility.

Eric Fry
for The Daily Reckoning Australia

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Your editor scratched his chin over this question while thumbing through a copy of the Financial Times over the weekend in the shadow of the le Grand Arche de la Defense west of Paris. You know the one. It's a modern, shiny, gleaming version of the Arch de la Triomphe.

Just why we chose to stay in the business district of Paris rather than down in the middle of the city...well it had to be a cost saving decision. It certainly wasn't aesthetic. This is Paris without the charm, pretty trees, and rich smelling coffee. In fact, with all the glass buildings and paved pathways, it could be any city anywhere during any credit boom. It's just another example of finance dominating the global economy.

And that returns us to the big question as we open the week. The financial markets have clearly rallied. If it's true that markets lead economies, markets are telling us that things are going to get much better. The FTSE index of emerging markets is up 99% from its March lows. The S&P 500 is up nearly 60%. And gold itself is up 25%, with much of that move coming in the last few weeks. This is what happened in 2003, all asset classes went up simultaneously, riding the global money tide.

David Rosenberg, who used to work at Merrill Lynch but is now the chief economist and strategist at Gluskin Sheff, says that something is fishy about this rally. It's come, at least in the U.S., as the economy lost another 2.5 million jobs. "Typically, by the time we are up 60%, the economy is well into the third year of recovery; we are not usually engaged in a debate as to what month the recession ended."

Fine, you may be thinking. Employment is a lagging indicator. It will be the last thing that picks up. But it will pick up. In the meantime, how can you ignore what the markets are saying?

One answer might be that the markets are rigged. Or, if that is too indelicate, you could say that the surge of liquidity provided by central banks has allowed banks to load up on assets again, producing paper gains which boosted earnings and justified-in the minds of some insane people-higher valuations for stocks. The bull is back baby! The economy should quite being such a party pooper and get with the program.

For example, during the same time that the U.S. economy has shrunk by about $400 billion in terms of GDP, the balance sheet of the Federal Reserve has grown by over $1 trillion. Japan has the same problem, a shrinking real economy and an expanding central bank balance sheet. GDP has fallen by £16 billion in the UK, but according the FT's Lex Column, the Bank of England has injected ten times that amount into the economy.

What does it all add up to? Why isn't an increase in credit leading to growth in the real economy? All that new money is not leading to a lending boom with renewed business investment that creates jobs and a recovery. Instead, it's leading to forced speculation in the stock market which is driving asset prices higher. This is the famous problem Alan Greenspan had with low interest rates. You can turn the credit spigot on, but you just never know where the money is going to flow.

Right now, it's flowing into stocks. Lex says that since Lehman collapsed, "US banks have increased their assets by 10 percent to $14.2 trillion." Rather than shrinking their balance sheets, the banks seem to have escaped the push for regulatory reform and actually loaded up again on free money for a credit-fuelled bender. Leverage is in vogue again, as are risk assets.

But we have no reason to believe this is going to end any differently than the last leveraged boom. We know how those end. We've seen bubbles popping steadily since 2000. First it was Internet and telecom stocks. Then emerging markets. Then common stocks. Then the commodities sector got pounded. And don't even get us started on how bad an investment sovereign government bonds issued by debtor countries are going to be.

All of that might sound unnecessarily grim for an Australian-based investor wandering the streets of Paris in late September. Can't we manage to say anything positive? Well....yes, we can! For example, last night's dinner of simple farm-style chicken in the shadow of the Sorbonne was...well it was excellent.

But what about investing? If you're going to have a plan for the next five years that takes into account this attempt to reflate the financial economy, there are a few things worth keeping in mind. First, it's going to fail, and probably spectacularly so. That failure will be accompanied by an even greater expansion of government debt.

For example, the Times of London is reporting that Britain's net debt is growing at a rate of nearly six thousand pounds per second. Tax receipts are plunging. And politicians, jack asses that they are, are actually making even more promises to deliver things they can't begin to pay for now.

We think they key idea in all of this is that you're going to witness a transfer of ownership in the underlying capital assets of the global economy. The big question is will you profit from it or be victimised by it? We reckon that if we're right-and if you can anticipate the general progression of events-you can stay one step ahead of the curve.

Easier said than done, right? So for the remainder of the week, we're going to go back and review our proposal for a "Permanent Portfolio." It will be based on a forecast of more debt deflation...and then rapid inflation.

Yes, it sounds tricky. But this isn't the first time this sort of thing has happened. Tomorrow, we'll take you back to one of the first "Great Inflations" Europe experienced and show you how it literally capitalised a new entrepreneurial class for the next three hundred years. Until then!

Dan Denning
for The Daily Reckoning Australia

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"Banks recover to their levels before the fall of Lehman," is a headline in this Monday's El Pais from Madrid.

"Public assistance enables the world's largest 15 financial firms to return to the capitalization they had in September 2008," the article continues. The largest of the largest, HSBC, is now judged to be worth $186 billion, according to the stock market. China's ICBC is on its heels, with a market cap of $178 billion. BNP Paribas is 7th at $87 billion.

We will overlook the compromising detail that banks actually lost money in the last quarter - more than $3 billion. And let's forget that China's major banks are sitting on mega-losses from more than eight years ago (to say nothing of the more recent losses). Western banks, too, still have billions in assets whose real worth is an open question...and subject to quick reconsideration...

El Pais goes on to report something intriguing: "The two big Spanish banks leave the crisis stronger."

Ah. What doesn't kill you makes you stronger. The world economy is recovering, or so people believe. Stocks are going up - led by the banks. But are the undead of the banking world really stronger?

Ha ha...don't make us laugh.

But the world seems to believe it. The Wall Street Journal reports that just five big financial stocks are behind the stock market's rally. Fannie Mae, Citigroup, Freddie Mac, Bank of America and AIG account for nearly a third of market's daily turnover. Seems everyone is speculating on the banks...and moving them higher.

You will recall, dear reader, the banks made a fortune during the bubble years. You may also recall that they made so much money that when the bubble years came to a close, that they were almost all broke. Without hasty action from the feds, it would have been the end of the road for every major bank on Wall Street. As it was, even with government help, none of them survived intact. They all either went bankrupt, were sold off, or got bailouts with strings attached.

What busted the banks was too much of a bad thing. They made their money by peddling debt. In order to move the stuff, they convinced clients that their products were good safe investments - even leveraged derivatives backed by subprime mortgages! Such good salesmen were they that they even convinced themselves. When the crisis came, they realized that they had been buyers of the debt...as well as sellers of it. What could they do with it...except sell it to the feds?

But the whole financial industry is coming back to life. According to El Pais, it's back...and it's better than ever.

But wait? How could that be? Hasn't the world entered the worst recession since the great depression? How could lending money be such a good business? People don't borrow in a recession.

Strategic Short Report's Dan Amoss is just as skeptical. "The banking system has no experience managing through the current 'negative home equity' environment," he tells us. "This is an environment in which mortgage rates are already about as low as they can get and consumer balance sheets are as stressed as ever. Due to the nonrecourse nature of mortgages, most borrowers have no financial incentive to keep paying. Many are choosing to mail the keys back to the lender.

"This problem will cap the upside of bank stocks for years to come, so the sector will offer lots of short selling opportunities."

Borrowing by households has fallen off a cliff. Instead of borrowing, they're paying back debt at the fastest rate since the '50s. No money to be made there.

How about commercial and business loans? Are you kidding? Businesses are cutting back too. Businesses borrow to expand...and there is no expansion going on. This is a contraction. Credit is contracting along with everything else.

Then, how could the banks make money? Let's refer to that news item again. Oh...there are the magic words: "Public assistance enables..."

The banks are making money the same way Detroit is making money...dishonestly and temporarily. Instead of doing honest deals with willing and able counterparties, the banks are pulling a fast one. Their money comes, ultimately, from the poor taxpayer...the poor sap who funds all the government's giveaways. The private sector lived far beyond its means during the bubble years. People wasted their money they didn't have on things they didn't need. Now, they try to save their money. But now the government wastes their money for them.

Speaking of which...a quick note on the Cash for Clunkers program. Numbers to be released today are expected to show a peak in sales in August caused by the feds' incentives. President Obama calls the program a showcase, proving how effective government can be at getting the economy back on the road.

But let's go back to basics. It's a sham when people waste their own money. It's a crime when they waste other peoples' money. Prosperity comes from accumulating (saving) capital...and using it to increase productive capacity. The formula is pretty simple: Save your money. Invest it in productive business. The Clunkers program encouraged people to do the opposite - consume capital, other peoples' capital.

'Nuff said.

Bill Bonner
for The Daily Reckoning Australia

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Cash for bankers! Cash for Detroit's clunkers! From one scam to the next...

But first, let us turn to the latest market update.

The Dow rose again yesterday - up 33 points, to close at 9,320. We set 10,000+ as our objective for this bounce. We'll stick with it for a while longer.

Make no mistake though. No one knows how long this rally will last - certainly no one here at The Daily Reckoning vacation headquarters. It will continue until it runs out of gas. That could be tomorrow. It could be months from now.

It will run out of gas sooner or later, and probably this fall. A real, durable bull market would require an economic boom - a genuine recovery. We don't see that happening...

But people must think it is happening...

"There are signs of a recovery in the US..." was a popular line at last night's cocktail party. Several friends mentioned it. Each time, we had the same reply - we wouldn't bet on it.

Yesterday, the price of oil rose; it ended the day at $71. And the dollar stayed where it was - at $1.44 per euro. Investors are betting on recovery - despite our advice.

And when the recovery turns out to be a clunker, they'll probably put these trades into reverse. Oil will go down; the dollar will go up.

You want to speculate, dear reader? Sell oil...buy the dollar. Wait for another crash this autumn.

Why will there be another crash?

Because people believe something that isn't true. People believe that there is a recovery...and that it is the result of stimulus efforts by the feds. The results from the second quarter show the economy still contracting...but at a slower pace, just -1% annually, rather than the -6.4% recorded in the first quarter. This is heralded throughout the world as proof that the crisis is receding.

"It if weren't for stimulus spending, the contraction [in the 2nd quarter] would have been closer to 4%," says the editorial in the International Herald Tribune. "The stimulus is helping...and more stimulus would help even more."

Oh? Would it? Let's look at stimulus-in-action:

'Cash for Clunkers' is a hare-brained scheme...but that doesn't make it unpopular. The idea is to stimulate demand by, well, giving people money. But instead of just giving them money and letting them choose what to do with it, the feds decide they need a new car. In order to the get the money, people have to buy one.

According to the press reports, the program has been a great success wherever it has been put in place - in France and Germany, as well as in the United States.

If so, why not apply the concept elsewhere? How about cash for houses? Cash for liquor? Cash for newspapers? Cash for trips to Europe?

What's so special about autos, in other words? And why is it a good thing for people to buy cars?

Oh c'mon, dear reader...don't pretend you don't know. The auto industry is huge...with many lobbyists and many organized groups interested in its wellbeing. It is an old and well-established industry with plenty of political clout.

Tomorrow's industries, by contrast, have no lobbyists...no organized labor...no pet congressmen...no political action committees. So who gets the money?

Here's the problem: the meddlers are not only up against tomorrow's industries...they're up against tomorrow itself. It's not as if Americans needed cars. Not at all. They've got plenty of wheels already. Three car households are typical. And they're fairly new cars. Americans were on a buying spree during the bubble era, 2001-2007; they bought new cars along with everything else.

So, the goal of the 'Cash for Clunkers' scheme is not to increase the size of the US auto fleet, it's to make it newer. People don't need more cars. They only need to replace cars that get worn out. If they bought a car five years ago, they may be ready to buy another one. Or, they could probably wait until next year. Along come the feds with cash...and the buyer decides to replace his car this year rather than next.

This is heralded as a success. The feds have stimulated demand. But what about next year?

We'll have more to say about this on Friday...but the auto example helps us see what a scam these stimulus schemes really are. They claim to boost demand. But they can't really increase demand. All they can do is roll next year's buying into the present year.

Sound familiar? That's the very thing that has been happening for the last two generations. Consumers didn't want to wait until they'd made the money to take their vacations or buy their houses. They turned to credit. They borrowed against future earnings. They spent money they hadn't earned yet...thus bringing forward purchases that should have been made in the future. That's why we have a depression; now, we're in the future!

It had to come sooner or later. After drawing consumption forward for decades, Americans had to stop. Time had to catch-up. Homeowners had to pay down debt. Ken Rogoff, Harvard professor of economics, believes it will take them 6-8 years to do so.

But consumers spent more than they could reasonably be expected to pay back. They out-spent the future! They bought a ticket to somewhere beyond the future...to a place where they would never actually arrive. In many cases - especially in the housing market - lenders discovered they couldn't get their money back, which is what led to the credit crunch and the collapse of Wall Street. Of the big five - Bear, Lehman, Goldman, JPMorgan and Merrill - only two survived intact. And we know now that Goldman only survived because Henry Paulson, former CEO of Goldman, then Treasury Secretary, arranged a hidden bailout. He had the government step in to save AIG, which owed Goldman $13 billion.

From one scam to another...that's the way the feds do it. From bailing out Wall Street they now turn to bailing out the entire world economy - in a similarly fraudulent way. Tim Geithner told the Chinese last week that the United States would revive thanks to increased private demand. But the feds cannot really increase demand in the private sector. Increasing real demand would mean increasing real wages. And there's no sign of that. To the contrary, incomes are going down.

Yesterday's news tells us that personal incomes went down 1.3% in June. Incomes had gone up in May, by precisely the same amount - 1.3%, thanks to stimulus payments. Then, too, commentators saw it as a sign of recovery. But what the feds gave in May was taken away in June. The future caught up with the Obama administration's stimulus efforts within 30 days. Net result = zero.

The June number reflected the biggest drop in income in four years. It is not surprising. We're in a depression, remember? Salaries and wages fell 0.4% in June...the 9th drop in the last 10 months.

Bill Bonner
for The Daily Reckoning Australia

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There's so much bad news about in the land that stocks moving up in such a climate is noteworthy. It means everyone's talking about how bad things are, but there aren't any sellers left. So are there any sellers left?

Well, over in New York there are. The Dow Jones made a new bear-market low at 7,465. It's a six-year low for the index, in fact.

Here in Australia things are more range bound. Kris Sayce produced the following chart in his weekly e-mail update to subscribers of the Australian Small Cap Investigator. The market is clearly trading in a range. You might even call it a range within a range.

As Swarm Trader Gabriel Andre says, these sorts of patterns don't last forever. Range-bound indices break out. But in which direction? If it's up, this is good news for the small-caps Kris tracks. Many of them have been absolutely battered in the last year. But if it's down...it means lower highs and lower lows. It is possible.

Take this for the complete psychological speculation that it is, but this "feels" a little like the moment last year when the oil price peaked. On June 27th of last year, when oil traded at $139.69, we wrote: "Our intuition is that you could see oil put a top in sometime in the next week, if it hasn't already happened."

That call was a few weeks early. But the idea at the time is one you should consider today. "Not that you want to step in front of a moving truck," we wrote." Markets can remain irrational longer that you can remain solvent, the old saying goes. We're not suggesting you bet against oil. But we are suggesting you take note of the sentiment. The bears have almost totally capitulated. The bulls are being whipped into froth. When any little thing drives the price higher, you have a very dangerous market."

Feelings are not very scientific. But maybe a sense of crisis-fatigue has set in and sellers are exhausted. That might make room for some profit-taking in gold and rebound/relief rally. Might. We'll see. But if we had to compare the market's selling exhaustion to a YouTube video, it would be this one.

If you wander over to YouTube, you might want to check out this video from CSPAN over in America. On the video , U.S. Congressman Paul Kanjorski explains what Ben Bernanke and Henry Paulson told Congress behind closed doors on September 15th, 2008, the day Lehman Brothers died.

Pay special attention to what he says between 2:14 and 3:44 of the clip. For those of you who can't watch it, Kanjorski says that the by 11 am that day, over US$500 billion had been liquidated from money market accounts. He describes it as, "an electronic run on the banks." He says the Fed told Congress that if action wasn't taken immediately, over $5 trillion would disappear from the markets by 2pm.

That's pretty precise forecasting isn't it? Whether the Fed was exaggerating, guessing, or in total panic mode isn't the point though. Kanjorski says the whole day threatened, "The end of our economic and political system as we know it."

You can't make this stuff up.

But then, Australia's own Central Banker has told Australian politicians that September 15th is a day that will forever live in financial infamy. He didn't use those words exactly. But in prepared remarks to be delivered to Australia's House of Representatives today, Glenn Stevens fingers the 15th as the day the world changed.

Shortly after the Committee last met" he begins, "the global financial system took a serious turn for the worse. On 15 September 2008, the American firm Lehman Brothers filed for bankruptcy. It was the biggest actual failure of a major American financial institution for many years. While it had been widely known that Lehmans was under immense pressure, when it came the event was still a shock. It triggered a massive re-appraisal of risk, and ushered in a period of the most intense financial turmoil seen in decades.

"The worst of the turmoil was actually fairly short-lived - a matter of weeks. But in that time a number of events occurred that have had a significant bearing on the outlook for the global economy. These included the incipient failure and/or public support of a number of major financial institutions in the United States, the United Kingdom and continental Europe, effective closure of many important capital markets and a worldwide decline in equity values of a quarter, leaving them around 50 per cent lower than their peak."

We'll leave any further discussion of September 15th's significance until next week. There are two other dates, though, that are critical to the story you now find yourself a part of. The first is February 4th, 1965.

That's the day French President Charles De Gaulle gave a press conference. It was a press conference that would begin undermining the post-war Bretton Woods international currency system. Why? It's what DeGaulle said about gold.

"The time has come," he said, "to establish the international monetary system on an unquestionable basis that does not bear the stamp of any country in particular. On what basis? Truly, it is hard to imagine that it could be any standard other than gold. Yes, gold whose nature does not alter, which may be formed equally well into ingots, bars or coins; which has no nationality and which has, eternally and universally, been regarded as the unalterable currency par excellence."

Over the next five years, French banks would begin redeeming American dollars for gold. The French could see America's war debt from Vietnam stacking up. Lyndon Johnson's Great Society program promised infinite butter along with a multitude of guns for the war in South East Asia. Government deficits soared.

Just over six years later, somewhere between August 13th and August 15th, Richard Nixon met with his economic Politburo at Camp David in Maryland outside Washington, DC. Against the advice of Federal Reserve Chairman Arthur Burns, Nixon decided to institute wage and price controls and, more importantly, close America's gold window.

We've been living with the world of free-floating fiat currencies and expansion of deficits and credit ever since. Lehman's collapse was one nail in the coffin of the modern financial system. De Gaulle built the casket in February of 1965. So what's the third date that changed the world? More on that next week...

Dan Denning
for The Daily Reckoning Australia

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But in terms of percentages, Monday's 6.9% decline in the U.S. doesn't even rate as one of the top ten worst one day percentage declines in history. Maybe that will come later this week. It might come in emerging markets.

The big story, though, is in the credit markets, which are in as bad a shape as they've been since the credit crisis began. The credit markets are vital to the banking system and the banking system is vital to anyone with deposits in the bank. This is how the credit crisis intersects with the real economy.

Remember, the whole target of the Paulson plan was to relieve pressure on banks. That pressure is right back on, following the failure of the U.S. House to sign on to the deal. That pressure threatens to spill over into the commercial banking sector, where we wonder what it will do the confidence of people who have money in the bank and not a lot of a confidence in the financial system at the moment.

Let's be clear about what we think the last two days mean: the Fed and Treasury are worried about the viability of the banking system. Why? Well, another bank was taken over in the U.S. (Wachovia by Citibank) and four European banks were effectively nationalised.

The trouble is as simple as it is intractable. The banks have heaps of assets on the balance sheet they can neither sell nor price. That alone is bad news. Write downs on those assets threaten to wipe out equity capital.

But if it were just a case of allowing a few institutions to fail, you'd have a run of the mill crisis. Not an epic one. After all, three out of Wall Street's five investment banks were allowed to collapse or forced to reorganise.

Officials and regulators might have been worried about the investment banks in terms of their counter-party risk in the credit-default-swap market. But Paulson and Bernanke let Lehman fail, arranged a marriage of Bank of America and Merrill Lynch, and threw Goldman Sachs and Morgan Stanley a lifeline by allowing them to become commercial banks.

Now, they must fear that the credit markets are threatening the retail banking sector. But how? Banks fund their operations by either deposits or loaning to one another. Those loans are sometimes overnight, sometimes longer. But the inter-bank lending market only works if banks believe that one another's collateral is good and loan to one another.

Much of the financial sector's collateral, though, is precisely the stuff that's falling value, namely securities backed by residential American real estate. Banks need each other to meet their funding obligations. But with the collapse in value of their main collateral, no one wants to lend. They all doubt each other.

The Paulson plan aims to cut the bad collateral out of the system like a cancer and replace it with Treasury bonds. But with the plan in tatters, the market is already anticipating more trouble and taking action. This action is removing another key source of bank funding: the money market. It's being taken because investors are beginning to wonder which retail banks might go under if the credit markets don't thaw.

With more and more investors doubtful about the bank's ability to survive write downs in their assets, or to secure funding, money is fleeing the money market for the short-term Treasury market (yields on 30-day Treasuries are just 0.066%).

This flight from the money market removes another key source of short-term bank funding, and puts the banks under even more pressure. This is why the Treasury moved to back-up money market funds last week. It was effectively asking investors not to remove money from the money- market by giving that money a Federal guarantee.

We're not certain the guarantee is going to ease anyone's mind in the current situation. We'd expect more money market outflows, further putting the screws to the banks. And though the Fed unleashed a torrent of overnight money to prevent a total drought of liquidity (nearly US$600 billion), the market is slowly coming to the realistation that more banks are going to fail as their assets reflect the market price.

There is a certain symmetry between Wall Street's behaviour and Main Street's behaviour. At the household level, some sellers refuse to lower prices on their homes because they do not want to take a loss. They believe the market will recover. But in the meantime, banks are selling foreclosed homes as quickly as they can. Prices continue to fall (affecting all those bank assets/collateral).

Meanwhile, financial institutions could probably unload a lot of their housing-backed debt on private equity and hedge funds-but only if they were willing to take a big haircut. That haircut would wipe out equity capital.

The banks want a deal that keeps them in business. They want the Paulson deal. But the U.S. taxpayers don't want the Paulson deal. They've said so all week. So where does that leave us?

It leaves us exactly where we've always had to be: the continued de- leveraging of the global financial system. That means more asset-write downs, more bank failures, and sooner or later, a run on a few banks as depositors begin to realise that the frozen credit markets are going to lead to the death of some over-leveraged banks unable to fund their operations or roll over their debts.

We may get Paulson Two, of course. Congress will cook up some other version of the plan that addresses things like equity warrants or taxpayer protection. But none of that solves the problem at the heart of the financial system: a tremendous amount of borrowed money has been invested in assets that are falling in value. The inevitable result is a credit deflation. There is no way of improving the quality of the assets.

The Fed is not waiting to see what Congress does to respond. It's about to grow its balance sheet in a monstrous way. It will take on new liabilities and create new money to do so if it must. That's why the only exception to yesterday's commodity sell-off was gold. We'll have more on this latest phase of the crisis in a special mid-week edition. Until then...

Dan Denning
The Daily Reckoning Australia

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