..how does it all work? We're doing some serious thinking this week. What is it that actually causes a depression? A stock market collapse? Or too much debt? How come government can appear to cure the problem sometimes - 2001-2007 - but not other times? How come the Japanese were not able to increase consumer prices? Even now...Japan's inflation rate is negative. And why is it, despite the most massive effort at monetary inflation ever undertaken, the US bond market still forecasts an inflation rate of less than 2%?

An interview with Richard Koo, author of The Balance Sheet Recession, and a new book by Ken Rogoff and Carmen Reinhart are helping us understand what it going on. More to come...

In the meantime, the Dow went down 42 points on Friday. Gold dropped $7. Still no sign of the Chinese coming to the rescue in the gold market.

"Global rally shows signs of running out of steam," says The Financial Times.

Reuters says the job data will "test the rally." The New York Times says the ratio between job seekers and jobs available has never been worse.

The Wall Street Journal, on the other hand, tells us that greater than expected profits will support the rally. So far, the increase in stock prices has not come from increased earnings. It's come from increased P/Es...based on the hope of higher earnings. In terms of forecast earnings, the Dow is selling at a P/E ratio of 27. But in terms of actual, reported earnings...the ratio if 180.

A friend made the mistake of asking us what to expect from the economy. We said it would go do down.

"You mean, you expect a W-shaped recovery," he said... "A double-dip recession?"

"No...we expect no recovery at all. It's a 'W' without the last stroke..."

Of course, we were exaggerating. But not much. We do not think that the economy of the Bubble Era can ever be revived. It will never recover...because it is dead.

But that's doesn't mean we will march backward forever. The economy may lose 10% of GDP...maybe 20%. But we do not expect to be slithering in the mud of the Middle Ages, with each man is planting his own wheat and brewing his own beer. No, not at all. It only means that the depression must continue until it comes to an end.

"But when will it come to an end?" you ask.

"When it is over."

A depression ends when it has done its work. It must correct mistakes. It must punish errors. It must destroy the bubble economy...and the mindset of the Bubble Era. Only then can new real, sustainable growth begin again.

So far, in 2009, 95 banks have gone broke. How many more need to go broke before the depression is over? We don't know. This is where is gets complicated. Because the feds are determined to keep us from finding out!

Here's how it works. The Fed lends the bankers money. Then, the bankers turn around and lend it back to the feds. The banks are happy; they're making money on a risk-free trade. The regulators are happy; what could be safer in a bank's vault than US Treasury bonds? Investors are happy; it looks like the financial sector is making money again. And the feds are happy; they're able to finance their deficits.

Who's not happy? So far, so good. But hold on...

"This is not a sustainable recovery," says fund manager Crispin Odey in The Financial Times.

What a spoilsport! You mean you can't build a lasting recovery on debt and shell-game finance?

Nope. Apparently not. Just look at what has happened to the auto industry. The feds borrowed money to help Americans pimp their rides. And this Thursday, when September sales figures come out, we find out how sustainable that boost was. Many Americans got new wheels. But now they don't need new wheels. And now the feds are out of the auto- incentive business. So now we get to see what happens next.

Stay tuned...

Bill Bonner
for The Daily Reckoning Australia

• Krugman Warns That the Run-up in Stocks Can’t Be Justified By the Fundamentals
• No Evidence of Recovery as Unemployment Getting Worse
• We Don’t Expect to See Australian Banks Suddenly Keen to Expand their Loan Books
• Where, Exactly, is this Economy Headed?
• Feds Can’t Cause a Genuine Recovery Simply by Throwing Money into Economy

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Whee! This investing stuff is easy!

Until next time,

The Mogambo Guru
for The Daily Reckoning Australia

• Dividend Drop-Off: When Cushions Turn To Rocks
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• Inflation Continuing to Wreak Havoc On Our Economy
• American Taxpayers Up to Their Ears in Debt

It is worth noting, that the Federal Reserve has already dropped the Fed funds rate to a historically low range of 0-0.25% and now it is desperately trying to use other unconventional methods (quantitative easing) to stimulate the economy. In my view, this latest development of the Federal Reserve monetizing debt is inflationary and confirmation that the Federal Reserve wants to debase the U.S. dollar. It is worth noting that the total debt in the United States now exceeds $60 trillion, and its economy is around $14 trillion. So, the United States is already bankrupt, and the only way it can ever hope to repay this gigantic sum is through monetary inflation and debasement.

Allow me to explain:

Suppose your grandparents borrowed $100,000 from their friends roughly 50 years ago. Back then, $100,000 was a lot of money, and the chances of your grandparents ever repaying this loan were slim at best. However, thanks to monetary inflation and the debasement of the U.S. dollar, today, $100,000 isn't a very large sum of money. Therefore, your grandparents would find it much easier to repay their debt.

Turning to the present situation, the United States owes its creditors a gigantic amount of money and a debt so large that it can never hope of repaying it in today's dollars. So, the United States has two options:

a. Default or bankruptcy

b. Monetary inflation

Given the fact that the United States is still the world's largest economy, owns the world's reserve currency and has a democratically elected government, I think we can pretty much rule out the possibility of sovereign default. Therefore, you can bet your bottom dollar that the United States will try its best to inflate its way out of trouble. Remember, politicians borrow money when it buys them a loaf of bread and they repay it when the same money is worth only a slice of bread!

It is my firm belief that over the years ahead, the United States, and all other debt-laden nations in the West, will engage in massive money- creation in order to debase their currencies and dilute the purchasing power of paper money. Remember, monetary inflation is a debtor's best friend, as it makes the debt easier to service and repay.

On the other hand, monetary inflation goes against the interests of savers and creditors. Given the fact that most of the 'developed' nations are up to their eyeballs in debt, you don't have to be a genius to figure out that monetary inflation is our future. At present, the global economy is dealing with deflationary forces due to credit contraction in the private-sector. However, even now, total credit in the United States is expanding due to rampant borrowing by the U.S. government. So, I don't expect deflation to take hold; rather, I anticipate accelerating inflation, which has always led to rising asset and consumer prices.

It is worth noting that apart from the Federal Reserve, other nations have also started monetizing their debt. Recently, the Bank of England announced that it plans to buy GBP150 billion worth of its government debt by creating money out of thin air. Needless to say, such a move is inflationary and terrible for the health of the British currency.

Now that we have established that monetary inflation is our future, let us examine which currencies and assets will maintain their purchasing power. If history is any guide, nations that engage in monetary inflation always diminish the purchasing power of their currency. So, in the years ahead, we can expect currencies in the West to depreciate in terms of purchasing power, but the trouble is that none of the fundamentally sound nations want a strong currency either! As the world engages in competitive currency devaluations, I expect all the currencies in the world to lose significant purchasing power against hard assets. Therefore, in the years ahead, precious metals and other commodities with intrinsic value should appreciate considerably. Even the values of fundamentally sound businesses with clean balance sheets should skyrocket as a result of inflation.

Last week, in the aftermath of the latest announcement by the Federal Reserve, we have seen significant strength in precious metals, crude oil and grains. Conversely, we have seen a huge decline in the U.S. dollar. If the Federal Reserve continues on this inflationary path, we can expect a resumption of the commodities bull-market and renewed weakness in the U.S. dollar.

Contrary to popular opinion, I am of the view that most commodities and stock markets have seen the lows for the entire bear market and we may be in the early stages of a new cyclical bull market that could last for a few years. Now, I am aware that my bullish stance may lead to ridicule from some of my readers, but I would like to point out that new bull markets are always born during abject pessimism and skepticism. Even if some asset prices break to fresh lows in the near- term, I suspect such a move will prove to be a 'head fake' and prices will soon rebound. So if you have a 4-5 year investment horizon, now may be a good time to convert some of your temporarily powerful cash into hard assets (precious metals, energy and industrial metals), related producing-companies and sound businesses in the fast-growing Asian economies.

At the current levels, the energy complex looks extremely attractive and should prove to be a fantastic long-term investment. After years of extensive research, I am convinced that the world's oil production is peaking and we are likely to see much higher energy prices in the future. So, investors may want to add to their positions in upstream oil/gas companies and the energy service stocks. Finally, it looks as though the precious metals complex is becoming over-heated and long- term investors may want to wait for the usual summer correction before adding to their positions in physical gold and silver.

Regards,

Puru Saxena
for The Daily Reckoning Australia

• How the U.S. Dollar Came to be the World’s Reserve Currency
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In my view, the above assessment is totally incorrect. After all, any student of economics will be able to tell you that if the money supply was constant, strong growth would not lead to higher prices. On the contrary, strong economic growth (increase in the production of goods and services) would result in price declines as the supply of “things” increased in relation to the amount of money available in the economy. Conversely, a weakening economy (decrease in output) would assert upward pressure on prices as the production of goods and services declined in relation to the amount of money available to purchase those “things”.

In the current monetary system, however, the supply of money is not constant and the central banks of this world are free to create as much inflation (money-supply growth) as they want. There is a catch – the central banks can only do so as long as they can keep inflationary fears in check by constantly reminding the public of the threat of deflation. Turning over to the current situation, it should not come as a surprise that in the past few weeks the media has published various stories comparing the recent downturn in the United States to the Japanese deflationary bust or the Great Depression of 1929. This “deflation” propaganda is crucial to further promote the Federal Reserve’s agenda of creating even more inflation as a “cure” for the ailing economy. Let there be no doubt that the Federal Reserve is now desperately trying to inflate the system via rate-cuts, pumping of liquidity and bailouts. And it is this monetary inflation and weak economic growth which is causing commodity and consumer prices to rise. Unfortunately, for the average American, this is occurring at a time when their economy is weakening, incomes are falling and unemployment is rising. In other words, I would argue that the Federal Reserve’s inflationary efforts are making things a lot worse for the majority of people.

My intention is not to criticize Mr. Bernanke, as I honestly feel that he is simply a cog in the wheel, an insignificant part within the overall system. Rather, I sympathize with him since he is now dealing with the mess which Mr. Greenspan created by leaving the Fed Funds Rate at a ridiculous 1% long after the U.S. recession ended earlier this decade. It is my firm belief that Mr. Greenspan’s ultra-loose monetary policies in the aftermath of the technology bust largely created the ongoing financial and credit crisis. And now, Mr. Bernanke is left with no choice but to continue with the inflationary program or else there would be a global economic depression. Due to Mr. Greenspan’s record-low interest-rates, American home prices skyrocketed between 2001 and 2005. However, they have fallen sharply in the past three years – and show no sign of bottoming out.

As an investment-manager, it is not my role to pass a moral judgment on the actions of central banks and governments. To be fair, given the level of debt imbedded in the West, central banks have no other option but to inflate. The problem though for the U.S. economy stems from the fact that this newly created money seems to be finding a home in commodities rather than financial assets. It is interesting to note that since the Federal Reserve started slashing interest-rates in August last year, energy, metals and food prices have gone to the moon, whereas the U.S. dollar and American stocks have plummeted. Unfortunately for the U.S. establishment, the “cure” of monetary inflation seems to be going horribly wrong as it is translating into even higher consumer and producer prices. I have long maintained that this decade would belong to commodities and the markets are proving me correct.

Over the past few months, the prices of commodities have gone through the roof due to supply and demand imbalances and massive monetary inflation. However, given the turmoil in the markets and loss of confidence, resource stocks have been punished by investors. This development is strange to say the least, and it has paved the way for a massive buying opportunity in the most coveted sector of the future. I find it absurd that the investment-community is dumping quality resource stocks at a time when the underlying commodity prices are super strong. At the end of the day, businesses are valued based on their corporate earnings, and with sky-high commodity prices, I can assure you that elite resource-producing companies are going to announce fantastic results in the months ahead. Today, top-quality diversified mining companies are selling at 12-13 times earnings (bear-market valuations) and I can only guess this is due to the fact that most people expect commodity-prices to crash in the months ahead. However, if my homework is correct and commodity prices continue to soar in the future, we will see a major re-rating in the valuations of resource-producing stocks. Some of you may remember that during the technology mania at the turn of the millennium, technology companies (even dodgy ones) sold for ridiculously high valuations. Well, we can expect to see the same type of madness in relation to commodity stocks in the future.

Puru Saxena
for The Daily Reckoning Australia

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So, what has happened in the world of money since we were gone?

Not too much, apparently.

U.S. stocks are still down about 7% for the year. The NASDAQ has lost 12%.

The dollar is still near its all-time low against the euro, at $1.57. And the yen, too, is near an all-time high. And gold?

Maybe we were right. Maybe we just had our last chance ever to buy gold for less than $900 an ounce. And maybe what we have now is our last chance to buy it for less than $1,000. The price today is $931.

We are bullistic on gold because we are realistic about human nature. Give someone an opportunity to print money and you can be sure that sooner or later, come what may, he'll take it.

The feds no longer tell us how much money they're 'printing,' but experts say M3, the broadest measure of new money creation, is higher than 15% per year. Let's see, money increases at 15% per year... and how fast is the supply of goods and services increasing?

Uh-oh... the IMF says the United States is headed for recession. Some economists think the country is already in recession. What that means is that the supply of goods and services is barely increasing at all. Which means, the extra money has to bid for the EXISTING goods and services.

No need to beat around the bush about it. What this means is that monetary inflation is driving up prices.

The price of oil is $112. Wheat, corn, soybeans, rice - all the grains are near record highs too. Many countries are banning exports. Many are controlling prices. (See below... ) Mexico, for example, has price controls on tortillas.

Of course, the real cause of rising food prices is a falling value of paper money. But only the European Central Bank seems to take its mission to protect the euro seriously - it's holding rates steady. While the ECB tries to hold the line against inflation, the rest of the world's central bankers are giving inflation all the slack they can. The Bank of England, following the U.S. lead, cut its key rate yesterday by a quarter-percentage point

Let's go back to our war analogy. It's a battle between the forces of inflation and the forces of deflation, we keep saying - one side unstoppable... the other immoveable.

But what kind of war is this? Glad you asked because we were thinking about that very question as we sat in front of the fire up in the mountains yesterday.

The Franco-Prussian war of 1870 was a great war. The French declared war on the Germans, for some reason that no one seems to recall. The Huns attacked, rolled up the French army... and laid siege to Paris. In the city, residents soon had to eat rats and cats to stay alive. Parisians exchanged recipes and made the most of it.

The whole thing was over fairly quickly. The Frogs capitulated, agreed to pay reparations, and the Germans withdrew (keeping the Teuton-speaking area of Alsace.)

It was a nice war because it had a clear winner... and because it was over like a good street brawl, before the cops came. And the Germans were very civilized about it. They didn't set up bases in France. They didn't stretch out the war for years... or make the French learn to speak German. They won it fair and square, and then went back to their strudel and frauleins. Which made Europeans think that war was not such a bad thing.

Then, came WWI. Oh la la... this was a war of a different sort. It went on for four years. At enormous cost to everyone... millions of dead... trillions in financial losses...

... and who won? Nobody.

We bring it up because this financial battle looks to us like that kind of war. A war of liquidation... in which people lose money they thought they had - either to inflation or to deflation.

Yesterday, Lehman Bros. (NYSE:LEH) liquidated three of its funds. And, as mentioned above, a big part of the stock market has been liquidated. And housing gains are being liquidated at about 10% per year...

... and remember, inflation liquidates almost everything... including the value of American labor. As consumer prices go up and the dollar goes down, the relative price of American labor falls. The working man is liquidated.

But if this is a WWI kind of war... everyone gets liquidated - investors, lenders, borrowers, consumers, businessmen, householders, working people... everyone. People who worry about money will have less to worry about, in other words.

Bill Bonner
The Daily Reckoning Australia

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• Inflation is an Artifice Caused by Government

Our hypothesis is that the fed's efforts to inflate will show up more in the gold market than in the stock market. That - and an instinct for self-preservation - is why we're long gold and short stocks. Stock prices depend, ultimately, on earnings. Gold's price depends, ultimately, on inflation. The feds can make more cash and credit available... but they can't wipe away all those bad debts, which are hurting earnings. That is, they can increase the rate of inflation... but not make businesses more prosperous.

We're witnessing a War of the Worlds - between inflation and deflation. We don't know which side will win, but we're betting that while inflation favors gold, deflation has it in for stocks.

But what's this? Yesterday, the Fed promised inflation - big time. It said it would pump in an extra $200 billion to fight deflation. Europe and Canada said they were in too - for another $45 billion.

Where does all this moolah come from... savings? Don't make us laugh, dear reader. It comes "out of thin air" as Keynes once said.

And what is the effect of pulling money 'out of thin air' and putting it in the money supply? More dollars... more monetary inflation.

According to our hypothesis, investors should see what's coming a mile away. They should have jumped to buy gold. Instead, they bought stocks. The Dow roared up more than 400 points. Gold barely went up $4.

So go figure. Still, oil hit a new high over $108. And sometimes it takes investors a little while to put 2 and 2 together. So, let's see what happens tomorrow before we come to a conclusion.

Besides, stocks may have gone up yesterday anyway; a rally was probably overdue. Commodities are at an all time high. Oil too. And more and more evidence comes to us that consumers are feeling squeezed... and forced to cut back on spending - which will further hurt business earnings.

"Surging cost of groceries hits home," says the Boston Globe.

"Paying at the pump, in a big way," says the New York Times. "Record fuel prices blow budgets," adds the USA TODAY.

"401(k)s tapped to save homes," it continues.

While rising prices pinch family budgets, falling asset prices pinch everyone. Most of the economy seems to be deflating. Housing is going down. Household incomes are going down. We'll have to wait a few days to find out what direction stocks are going.

The big picture still shows the same scene: America is getting poorer. Its money buys less stuff. Its working people earn less money. Its assets are worth less than they used to be.

"This thing is not about a recession or not a recession... and it's not about inflation or deflation. It's about re-pricing the U.S.A., downward. Sell America... sell its money... sell its stocks... sell its property... sell its politics... sell its economy... sell its I.O.Us. Sell it all," said a friend over the weekend. "It's clear to me that America's best days are behind it. The United States has had a disproportionate share of everything for too long - stock market valuations... the world's savings... the world's energy... the world's calories... the world's military power. That's what is changing. The world is readjusting... it's not getting out of balance; it's getting back in balance. It will be a world where the United States plays less of a role... and takes less of the world's resources."

He is probably right. Asia is growing much, much faster than the United States. Wages are going up 10% per year in China... 15% per year in India. Stock markets are booming. GDP growth in many foreign countries has averaged about three times the U.S. rate for the last ten years. Now, with the U.S. economy not growing at all... Asia is racing ahead.

We have no particular quarrel with this. America has enjoyed an extraordinary run of luck. She had cheap energy... history's most powerful military... and the world's reserve currency. Now she has the world's biggest debts... its highest deficits... and the most colossal financial problem ever. In short, it has passed its I.O.Us out all over town and now owes more money to more people than anyone ever did. It now has more financial commitments any nation has ever had (with a financing gap of $60 trillion - not including the cost of the Iraq War... which is expected to be as much as $5 trillion)... and has a competitive disadvantage against much of the rest of the globe. Asians make things cheaper. Europe makes them better.

How did such nice people get themselves into such a mess? Are Americans stupider than other people? Are they lazier? More reckless... more feckless?

Nah... we're just victims of our own good fortune. We had it too good for too long. A unique set of circumstances allowed Americans to borrow and spend more than anyone ever could before... and so they did.

As an aside, this turn of events for America is where we got the idea for the title of our documentary film, I.O.U.S.A. We are hoping to have an exciting update for you, dear reader, in coming days. Stay tuned. In the meantime, check out the film's website.

Bill Bonner
The Daily Reckoning Australia

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