February gold traded above $1,218 yesterday and closed at $1213. Gold has closed higher 20 of the last 22 sessions. In that time, according to Dow Jones newswires, it's up 15% - nearly double the return of the S&P 500.

Does this mean investors are starting to give up houses and shares and speculate on gold instead? The U.S. government has been forced to suspend sales of American Gold Eagle coins, according to Javier Blas in the Financial Times last week. It's the second time the mint has had to suspend sales since Lehman went belly up in 2008.

There's a bit more to the story, though. The mint has sold 1.19 million ounces of gold this year. That's a 75% increase over last year. Hmm. But it's also sold 26 million ounces of silver coins - the highest level of sales in 23 years.

What does this tell you? Well, the rational answer is that bullion or gold and silver coins are assets without counterparty risk. True, the value of gold and silver coins fluctuates with metals prices and liquidity. But your payment does not depend on someone else's credit quality. Your payment is in your pocket.

That rational answer presumes that investors are now showing a preference for tangible assets that are...real. But is it more fear than reason? After all, a rational investor might prefer the leverage you get with gold stocks as the best way to profit from rising gold prices. That would be the easier investment strategy.

But that suggests to us the move to gold isn't so much an investment strategy as it is a financial survival strategy. Investors are less and less worried about capital gains and more and more worried about the preservation of their purchasing power and capital itself. Gold is the ultimate expression of that worry - a flip side of the lack of confidence in modern monetary policy (or just modern money).

Gee. It's soooo kooky to distrust central bankers, isn't it?

Morgan Stanley appears to distrust UK central bankers. Morgan released a report yesterday, according to Ambrose Evans-Pritchard in the UK Telegraph, which highlights the risk that capital will flee Britain and the country will be plunged into a debt crisis because of a mix of political and economic factors.

"Growing fears over a hung parliament would likely weigh on both the currency and gilt yields as it would represent something of a leap into the unknown, and would increase the probability that some of the rating agencies remove the UK's AAA status," report Morgan's Ronan Carr, Teun Draaisma, and Graham Secker.

"In an extreme situation a fiscal crisis could lead to some domestic capital flight, severe pound weakness and a sell-off in UK government bonds. The Bank of England may feel forced to hike rates to shore up confidence in monetary policy and stabilize the currency, threatening the fragile economic recovery," the analysts wrote.

Hmm. No wonder gold is making new highs. And not just in U.S. dollars either. If the GFC really has become a sovereign debt crisis, the UK may compete with Dubai to see which political entity is the first to put to the fiscal sword (made, probably, of gold).

Of course those are American and British problems. So what if Australia will have $120 billion government debt in five years? That's as small as a percentage of GDP. Why worry?

Well, frankly, there is a lot to worry about in a global financial system still weighed down by debt. You wouldn't know it judging by the performance of stock markets this year. But we can feel it (psychic like that). And we can see it in metals prices.

We're off to Sydney and then South Africa next week. We'll have more to report on the outlook for precious metals then.

Dan Denning
for The Daily Reckoning Australia

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• Gold and Silver!
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• The Price of Gold is Low – But It Won’t Stay There Forever!

Dubai is still in trouble, as the local Bedouins said they weren't putting their full faith and credit behind the Dubai World debt.

We wonder how long it will be before the next pin pricks the bubble. Yesterday, The Financial Times said Greece was up next. Our own magazine, MoneyWeek, concurred:

"Las and inept, Greece is on a slippery slope."

But today, The Daily Telegraph Britain itself is sliding:

"Morgan Stanley fears UK sovereign debt crisis in 2010," is the headline story in the Business Section.

"In an extreme situation, a fiscal crisis could lead to some domestic capital flight, severe pound weakness and a sell-off in UK government bonds. The bank of England may feel forced to hike rates to shore up confidence and stabilize the currency, threatening the fragile economic recovery," said the Morgan Stanley report.

The situation is becoming clearer. Is it an illusion? Or is the fog really lifting?

We don't know. But what we see is what we anticipated 10 years too early - a long, Japan-like slump, punctuated with crises, bankruptcies, and defaults. At the end of the '90s it was said that Japan had lost a decade. Now, it is ten years later, and the Japanese are becoming remarkably forgetful; they've lost another decade!

The Japanese have spent the last 20 years trying to bring about a recovery. There were hopeful signs several times. But then, each time, the economy sank again into recession again...deeper than before. These stimulus efforts have been expensive, transforming Japan from a country with one of the world's best public finances to one with the worst. Debt to GDP is already at 200%. It will soon be 300% if the government continues spending at the current rate.

What have the Japanese gotten for all this effort? Tokyo stocks have rebounded a bit...along with the rest of the world. But consumer prices are falling again. And now the Japanese are getting older, faster than any other group in the world. It is as if the whole nation had retired and the economy has been pensioned off.

But Americans lost that last decade too. No job growth. No income growth. No stock market gains. And now, it looks to us as though the US is on track to lose another decade - just like Japan did.

What was lost to the first world's two leading economies was found by another part of the world that used to be known as the 'second' or 'third' world. India, China, Russia and Brazil have all grown by leaps and bounds - with income, stocks, GDP, prices, jobs...all up dramatically.

And now comes a report in today's paper that our favorite emerging economy is still growing, more rapidly than was thought.

"India's 7.9% growth spurt shatters forecasts," says The Financial Times.

This is good news for those who are hoping that emerging markets will provide the 'growth' needed to pull the world out of depression. The idea is simple enough. US consumers have slacked off. British consumers are out of money. European consumers are just naturally tight. And Japanese consumers are in a coma.

So, who's going to do the consuming? Where's the growth going to come from to keep Chinese factories polluting the atmosphere and Indian call centers confusing the customers? Well, from India and China...and Brazil and Russia...and the rest of the emerging world.

And here's an interesting bit of information. Nouriel Roubini recently commented that there is no way the Chinese can replace American consumers. US consumption is 10 times greater than Chinese consumption. But he must have different information from a French fund manager who calculates that Chinese consumption has more than offset American thrift. At their peak in 2007, Americans were spending 380 billion per month at the retail level. Now, the figure is close to $345 billion - or a reduction of $35 billion a month.

Meanwhile, Chinese consumer spending has jumped from $110 billion a month to $150 billion - $40 billion more, and more than enough to compensate for Americans' new found frugality.

At this rate, China will soon be redirecting its productive capacity - as India always has - at its own domestic market. It will cease being a major exporter and, if you can believe it, will become a net importer.

If this were to happen as forecast, it would open an avenue for America and its crony economies to escape from their Lost World. They could turn their economies from import to export...from consumption to production...from taking to making...and from trade deficit to trade surplus.

Sounds simple enough. But wait...there's more. In order to sell things to the Chinese and the Brazilians, you're going to have to be able to compete either on price or on quality. It's hard to see how the US could compete on price, unless inflation cuts the price of US labor substantially. As to quality, typically, it has been the Germans, Italians and French who have the upper hand. The Germans make the precision tools. The Italians make the handbags. The French make the yoghurt. What does that leave?

Well, there's still some room. But it will take time to gear up for it. Your editor, for example, has planted his flag - not the Crash Alert flag...his company flag - in India. He would like to plant a flag in Brazil too. But he's not counting on these foreign ventures to pay profits anytime soon. It takes 5 to 10 years before a start up business really gets some momentum.

Between now and then, there are bound to be booms, busts and blow-ups.

What is true for our business is surely true for an economy. It takes time...trial and error...mistakes and corrections...training...boom, busts and blow-ups before something really works. And another lost decade or two...

US personal income rose in October. But it was boosted by government benefits, says David Rosenberg. Take away the free money from the feds and income actually went down.

Income has been going down for a long time in the US. English colleague Brian Durrant wonders why there is no revolution:

"Consider a country. For the top 20% of the population real incomes have increased by 60% since 1970. But for the other four-fifths real income has fallen by more than 10%. Am I talking about Guatemala or Bolivia? These sorts of inequalities have in the past provoked resentment sometimes articulated through revolutionary movements and social unrest. But I am not talking about a tiny Latin American state; these figures apply to the US. How can this be? Middle class America is surely better off compared to 1970; if you look at higher car ownership, better housing, more white goods and gadgets. The answer is debt. No wonder the politicians are frightened of it contracting!"

We have been saying that the last 10 years was a 'lost decade' in terms of income, employment and stock market growth. For most people, their whole adult lives have been spent slipping backward. Since the Carter Administration, the typical American has lost income. A whole generation made no financial progress.

But they didn't revolt. Instead, they borrowed. It gave them more gadgets, gizmos and floor space. It also gave them the impression that things were getting better. Now we've reached the end of that period of debt expansion. Now debt is contracting. So are lifestyles...And so is the foundational American faith in free enterprise.

America flourished because its people believed in free enterprise and controlled public spending. Now, they seem to believe the exact opposition. That business must be carefully controlled...and the feds can spend however much they want.

But check this out. Now, people in communist China have more faith in free enterprise than Americans do.

Bill Bonner
for The Daily Reckoning Australia

• Investors Better Off Investing in Anything but Stocks
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• US Economists Think China Should Raise the Value of Yuan
• Saving Money, Not Spending it, is the Key to Getting Wealthier

Since it peaked in 2007, the UK stock market lost 60% of its value. As of yesterday, it had recovered half of what it had lost.

All over the world, the story is about the same. Markets have recovered half or more of what they gave up.

The US is a laggard. While the S&P is up 60%, the Dow isn't yet at the halfway point. Some foreign markets, meanwhile, have 100% + gains.

Fund managers who missed the rally are kicking themselves. They've failed to keep up with the benchmarks.

Even before the market headed up in March we echoed Richard Russell's words: "One of the surest phenomena in the financial world is the bear market bounce," he said. We also guessed that the bounce would go to about half the previous losses. We based that on what had happened after the Crash of '29.

Well, we're still not there. But an analyst from Morgan Stanley tells us that markets tend to do better than that. The typical bounce is about 70%, says he.

Whew! That's a pretty serious bounce. If we'd known it was going to be that big we would have encouraged dear readers to bet on it. Instead, we judged it a dangerous countercurrent...like a back eddy or rip tide. Yes, it can take you places...but not necessarily where you want to go!

Our outlook here at The Daily Reckoning is very long term. We don't like betting on countercurrents...even important ones. Instead, we like to go with the flow...and keep going with it until it arrives at its end.

That's not as easy as it sounds.

In 1999, it looked like the bull market had come to an end. We thought so. We told readers to get out of stocks...and stay out. Gold was a better place to be.

Investors made nothing in stocks for the next 10 years. In real terms, the stock market decline began in January 2000. Prices went down. They bounced...such a big bounce that it looked like a genuine new bull market. But after inflation, there wasn't much left. Adjust for purchasing power and investors were worse off every year. Even now, after a 7-month bounce and a 45% gain, Dow investors are still down 30% to 40% from the highs set in 1999.

Dave Rosenberg...

"The only thing we really learned in this extremely flashy, seven-month, 60%, nine-point multiple expansion-led rally, is that momentum investing never did become extinguished this cycle. It is really a fascinating commentary on human behavior that so many 'investors' are lamenting about how 'the train has left the station' without them. Please, give us a giant break! The train has left the station countless of times in the last 10 years but obviously none of these trips lasted very long because the reality is that equities have failed to generate any positive return over this time interval.

"As for the here and now, there is another reality. Price gains in the stock market have generally occurred with low volume. There are limited buyers - hedge funds and flash traders - but no sellers (not yet, anyway). And, we saw in yesterday's decline that volume climbed across the board, and the number of high-volume selloffs is a major red flag that should not be ignored."

The typical major bear market lasts 15-20 years. The last one began in 1966. It wasn't until 1982 - 16 years later - that the next major bull trend began.

This bear market is already 10 years old. Perhaps it will end in 2015. Maybe in 2020. We don't know when. We only know how it will end - in misery.

Now, despite 10 years of stinkin' returns, investors still believe in stocks. They still hope to find the 'next Google.' They still punish fund managers who hold back. They still read the financial press. They still watch CNBC. They still want to know what stock to buy.

Yesterday, they bid up the Dow 131 points. The price of stocks to gold is about 10 to 1. When this trend began ten years ago, we predicted that the Dow and gold would go all the way to 1 for 1. We guessed it would happen at the 3,000 to 5,000 level. We'll stick with that prediction until it proves correct...or it makes us look like a fool.

Bill Bonner
for The Daily Reckoning Australia

• Every Major Bull Market Needs a Major Bear Market
• Stocks, Bonds and Economy All Bounce
• In a Bear Market Most Stocks Go Down, So What Do You Do?
• Your Second Chance to Escape the Bear Market
• Is the Bear Market Rally… the Suckers’ Rally

The challenge of today's Daily Reckoning is to separate the short-term trends in financial markets from the long-term trends in geopolitical history. It's a big challenge. But let's break it down and see where we go. And let's begin with U.S. Bank Wells Fargo.

The Dow Jones slipped under 10,000 at the end of the day Wednesday largely because analyst Dick Bove changed his call on Wells Fargo from "neutral" to "sell." Bove said the quality of the company's third quarter earnings was, "pretty poor." "If you take a close look at the earnings, what you can see is that the improvement is due to a hedging profit made on the mortgage service portfolio, about $3.6 billion...You can also see that they cut their tax rate," he told Dow Jones news wires.

Imagine that; a major bank boosting earnings with one-off events. This is why we said last week that quarterly earnings (and whether they are above or below analyst expectations) don't always tell you what you need to know about a business. Granted, Bove is still bullish on Goldman, Morgan Stanley, and Bank of America. But his comment set off a small chain reaction on the Street.

It was a weird reaction too. Stocks fell and the Aussie dollar briefly faltered against the greenback. But commodities like oil and gold continued to power ahead. Oil is at a 12-month high and trading over US$81. Gold futures again traded above $1,060. And the U.S. dollar kept falling against commodities and other currencies.

So does this disprove our trading idea that the dollar index is due for a rally? Nope. The index could make a new low below 70. And that would certainly confirm what we already know: the rest of the world is on to America's habit of living way above its means. The dollar index could plumb a new low until there is an improvement in America's trade deficit or its fiscal deficit. However...

Don't discount the rally! "We should be prepared for a counter trend rally," wrote Slipstreamer Murray Dawes earlier this week. "RSI are entering long term oversold levels (although in a downtrend they can remain oversold for long periods of time of course and so are not a good trading signal against the trend) and market news is constantly bearish the US dollar so trader positions may be getting a bit full up on the short side."

"A short squeeze would not be out of the question, but I would not be trading a squeeze unless it breached the 81 level to confirm the re-entry into the last year's range," Murray concluded. A short squeeze in the greenback would see oil and gold correct, along with the Aussie dollar and stocks. Mind you this is a trading trend, not a long-term investment call. But we're tracking it and will keep you posted.

For a top-down view of just what's happened to the dollar this year and what it means for your investments, have a read of David Einhorn's speech at the Value Investor's Conference in New York City. It's a real page turner. And it's only eight pages!

Einhorn made a few great points worth considering. The first is that Australians should watch out for a second period of slower growth (maybe even recession) once the effects of the stimulus exhaust themselves. It wouldn't be the first time something like this happened. The attempts to stimulate America out of the Depression boosted GDP for a few years, but didn't solve any of the problems which really ailed the economy.

"An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fallout. Our [America's] choice may be to maintain large annual deficits until our creditors refuse to refinance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline."

Einhorn is writing about the U.S. In Australia, the government is hoping the removal of the fiscal stimulus won't result in "significant economic fallout." It must be hoping that capacity expansion by the mining industry is enough to support employment and consumer spending...and that house prices (and home building) keep the rest of consumer spending buoyant...and that businesses begin to reinvest.

That's a lot of hope. But hope has been pretty easy to sell these days.

The other factor which makes Australia's situation slightly different than Americas is that funding Australia's comparatively small deficits shouldn't be too hard, given the strength of the Aussie dollar. Not that racking up long-term debts to China or other foreign creditors is good, especially when the borrowed money is just going to your mates in the building industry or to prop up select retailers.

But it's probably true that Australia's creditors won't squeeze the government until much later, after the current government has been replaced. That will happen years down the track, when tax payers will still be paying off today's debts. Perhaps they will be wondering why no one [today] thought it was immoral to steal money from the future in order to maintain over-leveraged lifestyles today.

But that is the future's problem. So we'll let them deal with it. Einhorn is right to point out that policy makers tend to favour short-term benefits over long-term prudence because it's easier to get elected that way. And news organisations always spin the policy in terms of who the narrow groups that benefit rather than the unknown parties in the future that don't. But maybe this is just too abstract a point for people to understand these days. In any event, years down the track when Australia is paying off its debt to foreigners, the question may come up again.

Today, there are other more critical events that could rock financial markets. "As we sit here today, the Federal Reserve is propping up the bond market, buying-long dated assets with printed money. It cannot turn around and sell what it has just bought," Einhorn says.

The Fed has no exit strategy! The U.S. bond market has become a quagmire from which Geithner/Westmoreland and Obama/Johnson cannot escape! But hyperbole aside, what does that really mean?

It means that TARP and TALF and CAP may eventually wind down. But the Fed is subsidising mortgage rates and short-term Treasury rates in the U.S . This is what's going to drive the next down move in the dollar and the dollar index (it will make new lows). The Fed will continue "monetising the debt" and there will be fewer and fewer foreign takers (willing to finance U.S. deficits by buying bonds and notes).

This quantitative easing is incredibly bullish for gold. And it's a liquidity trap for the Fed.

"There is a basic rule of liquidity," Einhorn says. "It isn't the same for everyone. If you own 10,000 shares of Greenlight Re, you have a liquid investment. However, if I own 5 million shares it is not liquid to me, because both the size of my position and the signal my selling would send to the market. For this reason, the Fed cannot sell its Treasuries or Agencies without destroying the market. This means that it will be challenged to shrink the monetary base if inflation actually turns up."

We'd argue there already IS inflation, but it's in assets...stocks, bonds, commodities, and real estates. The Fed's nightmare is that it is unable to shrink the monetary base without collapsing the Treasury market (sending yields to the stratosphere). You'd get a collapse in asset values and devaluation in the dollar, which, in the real economy, would lead to rising prices. A loss of net worth coupled with a rising cost of living...is not a good formula for getting re-elected.

And one more point on the U.S. debt. It is now extremely interest rate sensitive, as we wrote here in April. Einhorn writes that, "The Treasury has dramatically shortened the duration of the government debt. As a result, higher rates become a fiscal issue, not just a monetary one. The Fed could reach a point where it perceives doing whatever it takes requires it to become the buyer of Treasuries of first and last resort."

Besides taking U.S. monetary policy into the land of the absurd, you would also want to buy long-dated calls on U.S. interest rates if Einhorn is right. You can trade it two ways actually. You can be short U.S. bond prices through exchange traded funds like TLT and IEF, or long U.S. bond yields by buying call options on U.S. Treasury yields.

And what about the other dodgy currencies like the Euro and the Japanese Yen? They are doing well against the Greenback now. But at a fundamental level, both have the same genetic defects as the U.S. dollar. "I believe there is a real possibility that the collapse of the major currencies could have...a domino effect on re-assessing the credit risk of other fiat currencies run by countries with large structural deficits and large, unfunded commitments to ageing populations."

The "domino effect" Einhorn is referring to is the collapse of Lehman Brothers. For at time, until it was clear the government would not allow the other investment banks to fail, it was clear to investors that if Lehman's leveraged model was dead, so was Goldman's and Morgan Stanley's and Merrrill Lynch's.

In a world where credit was not so ready and the unwinding of leveraged assets threatened to wipe out equity capital, those major levered up firms faced an existential threat. The government stepped in at that point and bailed them out, preventing the free market from doing what it was about to do: punishing the firms, their creditors, and their shareholders for incredibly bad risk taking.

Now you have the goofy situation where a government pay Czar is intervening to cut executive salaries at those firms by 90%. If the government hadn't intervened in the first place, the salaries would have been cut by 100% and the bad bets by the firms would have been written off and the economy would be closer to recovery. But that is neither here nor there.

Einhorn's warning is that currency devaluations force investors to revalue the idea that sovereign bonds are risk free. This is another way of saying that the nation state as a fiscal enterprise is every bit the failed model that investment banking is today. Investment banks borrowed money to bid up assets. Governments borrow money, securitised by tax revenues, to "invest" in policy objectives.

But as we are finding out now, those "investments" have not been self-sustaining in an economic sense. Einhorn, if we read him right, is reaching the conclusion that the nation state financial model (the fiscal warfare/welfare state) is in deep, deep trouble. It is the next institution that is "too big to fail." And it's going to fail because its funding model is based on the fraud of an idea that we can all live at one another's expense and that you can get something for nothing.

Here's a question, though: who bails out a failed nation state? Will the IMF bailout America? Will the World Bank lend to Japan? Will China establish a line of credit for Europe?

Speculators who like what Einhorn is saying would consider buying long-term put options on the Euro and the Yen too, not just the U.S. dollar. But what do you do if you're not George Soros? Why not try gold?

"I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible."

Sounds pretty sensible.

Dan Denning
for The Daily Reckoning Australia

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• U.S. Treasury Auctioning Off $81 Billion in New Debt
• HSBC Reveals Days of the Dollar are Numbered

Roach was what I call a realist, but he was more commonly labelled a bear, a pessimist, and a crank. When the market was soaring to new highs, Roach spoke about his professional ostracism, where so-called colleagues would pass him by, their heads lowered in embarrassment...for him, not themselves, in being so stupidly bearish.

Perhaps for the stress that this treatment brought about, Roach slightly wavered in his conviction and become more sanguine about the global economy he had for years rightly poo-poohed. This was just before credit markets began to seize up.

But he hasn't turned to the sunny side, in all its unthinking radiance, just yet. Roach began a recent column for the Financial Times with, "Hope always seems to spring eternal in liquidity-driven financial markets. That is very much the case today in the aftermath of the biggest liquidity injection in modern history."

Hope is indeed springing eternal, and it is again unfashionable to be pessimistic. Brokers, analysts, and investment bankers are doing a roaring trade in peddling hope over reality, and it pays very well.

Such behaviour is a product of ignorance and, more importantly, the massively conflicted financial services industry. That industry has developed and grown throughout a 25 year bull market. It is an industry plagued by overcapacity, groupthink, and incurable optimism. It is hopelessly ill-equipped to deal with the prolonged bear market we are now entering into.

That may sound like a dumb statement considering the ASX has bounced by more than 50% from its March lows and the S&P500 has surged by around 60%. But bear market rallies tend to be very convincing, and this one appears to be convincing just about everyone. Global central bank induced liquidity is driving this rally, along with huge fiscal stimulus. The fundamentals remain terrible.

As Roach says in his FT commentary, the policy responses have done nothing to correct the global imbalances that caused the crisis in the first place. He writes that, "US authorities cannot resist opting for another dose of excess consumption - despite the fact that the consumption share of real gross domestic product remains at a record high of 71 per cent.

"Nor can the Chinese wean themselves off investment-led growth - even though the fixed investment share of their GDP appears to have surged beyond the already unprecedented reading of 45% in mid-2009. Far from rebalancing, an unbalanced world once again appears to be compounding existing imbalances."

Why let sober reality get in the way of a good market rally? Instead of cautioning their clients to take money off the table as the market has surged from undervalued to overvalued, most market cheerleaders have become more delirious. The reasons to be bullish? The market has bottomed (for good, apparently) and there is still a huge amount of cash on the sidelines waiting to enter the great game (without needing substitution) the recession is over, and people are more confident.

There's a term for such behaviour and it's called "making hay while the sun shines." The clouds have indeed broken over the past six months and the sun is shining through. The finance industry sees an opportunity...get that cash off the sidelines, put it to 'work' and clip the ticket on the way through. All is normal again.

But is it? Normal for whom? For the industry, or for the people the industry is meant to serve. I have a number of questions I'd like to ask the optimists.

What does cash on the sidelines mean? If you're referring to money market instruments, like bank bills, short term commercial paper and short term government debt, why are these interest rates not rising around the world, signifying the flight from 'cash' to higher risk equities? Could it be that freshly minted central bank stimulus is flowing into risk assets, while the 'cash on the sidelines' is displaying more inertia that initially thought?

I would also ask the optimists what has changed in the global economy over the past year to make them so...optimistic. How does a huge increase in government debt do anything but provide a short term boost, masking long term structural problems? How can more debt solve problems caused by too much debt? How do they expect ultra low interest rates - which encourage consumption and discourage saving - to correct the imbalances?

I'm guessing the answers would have something to do with faith in governments and policy makers to get us out of this mess. The fact that they didn't see the mess coming doesn't seem to register.

Roach's analysis is far more realistic. He writes that, "This [government attempts to 'fix' things] is the same dubious script the world followed in the aftermath of the bursting of the equity bubble in the early part of this decade. And look how that ended. With far more excess liquidity currently sloshing over into asset markets, there is great temptation to erase the memories of the Great Crisis. Therein lies a pitfall for the markets - as well as for a still unbalanced post-crisis world.

After a 50% fall on the ASX, which occurred from the 2007 peak to the low back in March, many market pundits were 'cautiously optimistic', the correct call given the significant amount of value opportunities. Now, after a 50% rise from the March low, and the absence of any attractively priced companies, the correct call is to be cautiously pessimistic.

Greg Canavan
for The Daily Reckoning Australia

• Oil Prices Has The Mogambo Guru Sticking His Thumb in His Eye
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• Rosenberg Let His Clients Know He Thought the Sucker’s Rally Was Over

The Dow was up 120 points yesterday. Now, we're beating the bounce of 1930. The post-crash bounce in 1930 lasted fifth months. Ours began on March 9th...so it is now in its sixth month.

And like 1930, people are coming to believe that recession is almost over...and happy times are here again.

Heck, we're sure the trouble is behind us now; 53 economists said so!

According to Bloomberg:

"The economy will expand 2 percent or more in four straight quarters through June, the first such streak in more than four years, according to the median of 53 forecasts in the monthly Bloomberg News survey. Analysts lifted their estimate for the third quarter by 1.2 percentage points compared with July, the biggest such boost in surveys dating from May 2003.

"'We've averted the worst, and there are clear signs the stimulus is working,' said Kenneth Goldstein, an economist at the Conference Board in New York.

"'Cash-for-clunkers was the icing on the cake,' said David Greenlaw, chief fixed-income economist at Morgan Stanley in New York. 'It's well- timed stimulus syncing with cyclical forces leading to a ramping up of production.'"

Yes, now the economy is firing on all cylinders...or just about. Yep. No doubt about it. Still, there are some nagging doubts. The latest figures show foreclosures still increasing - up 7% in July from a year before. And house prices are still going down. And unemployment is still going up. And consumer prices are falling...indicating a Japan- like deflation. And business profits are falling. And consumers are cutting back. But except for that - housing, jobs, sales, profits and deflation - everything is working out beautifully.

Now that we mention it, all the indicators of real economic activity are down.

So, the feds aren't taking any chances. Yesterday came news that the Fed would continue buying bonds at least through October. And they are not likely to raise rates either. The banks can borrow at practically zero interest...and use the money to buy Treasury bonds. The 10-year yields about 3.7%. In effect, they're lending the money back to the people they got it from...and earning 3.7% for their trouble.

But, take away the stimulus spending...and the stimulating low interest rates...and what have you got? You've got is an economy entering a depression.

Oh, there's the rub, isn't it? If the feds hand out money so people can buy automobiles, people buy automobiles. If they don't give out the money, people don't buy automobiles. If they buy automobiles, of course, it looks like the economy is recovering. But take away the giveaways, and the recovery disappears.

Solution: keep giving away money!

Hold on...something wrong here. If you could generate economic prosperity by giving people money so they could buy things...why not give them money to buy everything? Why just autos? Why not give them money to buy financial advisory services? Ah...now we're talking!

But let's keep this serious...well, as serious as we can be when we talk about programs designed by knuckleheads.

So, the feds are encouraging people to buy autos. Set aside the fact that buying too many autos and other things is what got them into trouble...

..if giving people money so they could buy things actually made people prosperous, welfare recipients would be the richest people on the planet. Obviously, it doesn't work that way. What makes people rich is the ability to earn money...not their ability to get handouts. And remember, too, the feds don't really have any money to hand out. They can only get money by taking it from its rightful owners - either in taxation or loans. Or, they can print it up themselves. In any case, the money adds nothing real or extra to the economy. It merely distorts the economy...twists it...misleads it...and makes it a bigger mess than it was already.

Bill Bonner
for The Daily Reckoning Australia

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The government wants people to understand their money is safe in the banks. That's why that last bit is in there. It's designed to keep foreign holders of Aussie dollars from engaging in a run on the dollar and bringing their money home, wherever home might be (Japan, for example).

The Australian dollar is up in early trading. But its huge slide in just a few months is remarkable. It's good for exporters (especially farmers). Aussie agricultural goods now become relatively cheaper on foreign markets. It's not as good for consumers, who could see higher prices on imports (and there are a lot of imports in the consumer goods sector of the economy).

The big question, of course, is how shares will react to the weekend's events? So far so good. They're up 6% in early trading.

Polling the crowd this weekend and the Melbourne Investment Expo, we got the impression that there was a bit of capitulation on Friday. Investors who could not afford to lose anymore capital may have exited the market during the big 8.3% slide. Fear gave way to abject terror.

There may also be another reason-aside from the panic in the banking market-for Friday's frenzied selling. When Lehman Brothers was allowed to fail, it defaulted on some US$130 billion in senior debt. Against that debt, hedge funds and other Wall Street investment banks had sold some US$400 billion in credit default insurance.

Remember, anyone can sell credit default swap (CDS) insurance. It's a little like writing options. You collect the premium and hope you never have to pay out on the policy. So firms like Goldman Sachs (NYSE: GS), JP Morgan Chase (NYSE: JPM), and Morgan Stanley (NYSE: MS) sold huge amounts of credit insurance against default in Lehman bonds.

One theory making the rounds last week was that those investment banks and hedge funds were selling assets and hoarding cash in preparation for judgement day on how much of that insurance they would actually have pay out. An auction was held last week to determine the value of the outstanding Lehman CDS.

Based on the results of the auction, it looks like anyone who sold default insurance on Lehman bonds will have to pay out around 90.25 cents on the dollar to the holders of the CDS. Obviously, that could be a huge number, based on the gross value of the CDS outstanding ($360 billion). But if the banks and hedge funds have already hedged against their risk in writing these credit default swaps, it won't be any big deal.

If, on the other hand, you were a hedge fund selling CDS on Lehman's debt without making any provision that you'd actually have to pay up, well you, my friend, are in a sorry state. And you were probably selling assets like cheap underwear to raise cash last week. What does any of this have to do with the Aussie share market?

Blue chip Aussie mining shares like BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO) and OZ Minerals Limited (ASX: OZL) have been the darlings of hedge funds wanting to own commodity stocks. The Aussie dollar has also been a popular commodity currency and yield play. If hedge funds and investment banks were liquidating commodity positions to raise cash for the Lehman CDS auction, it would most likely hammer Australian stocks.

That's one reason Aussie stocks fell much harder on Friday than stocks on Wall Street. Australia has a high percentage of stocks that were attractive to leveraged speculators when commodity prices were high. Now, those assets have seen a large amount of selling. With the Lehman CDS auction behind us, will the selling end?

We'll see. Beyond Lehman, there are the larger issues in the global financial system. On that score, politicians in Europe raced against the opening of global markets this morning. They announced a package of reforms that would: guarantee interbank lending, guarantee debt issued by banks until 2009, give government's permission to buy preferred shares in banks, make provisions to directly recapitalise any banks that were deemed "systemically critical."

While the Euro nations try to unfreeze the banking sector by effectively guaranteeing all lending, regulators in the U.S. and the U.K. are taking similar steps. The British government will take controlling stakes in the Royal Bank of Scotland and HBOS Plc. The Brits have also decided to inject about A$125 billion in capital directly into the banking system.

We covered the big-picture implications of this policy response in yesterday's special Sunday edition of the Daily Reckoning. If you missed it, you can find it here (Australian Resource Shares, What's Next). But it's not hard to see what's going: government guarantees to all bank lending, and direct, unsecured government lending to anyone who asks for it.

Will putting more money (credit) into the hands of those who created the problem in the first place actually help? Probably not. As Jim Rogers told CNBC, it's setting the stage for an 'Inflationary Holocaust.' It's hard to believe at first that the current deflation in financial assets will give way to astonishing inflation. But that's just what we expect to happen.

Specifically, governments will boost lending to the private sector via central banks. You can also expect direct stimulus for households via rebate packages and tax breaks. In the long-run, big government spending programs on public works, infrastructure, and energy are a certain political winner.

And where will the money come from? Good question. It will be printed or borrowed into existence. Money supply will rise. And with the banking sector effectively nationalised, private investors will look for a real hedge against the inflation being unleashed.

We would take a strong look at over-sold Aussie oil stocks right now. Not only are they over-sold from a technical perspective, but the oil price has nearly halved from its highs earlier in the year. You may not get a better chance to buy them at this price.

Of course, if the market gets any worse than it got last week, it will no longer be the worst financial crisis since the Depression. It will be the worst financial crisis of modern times, full stop. If that is the case, it marks the end of one era and the beginning of another.

In the meantime, however, you could do worse than build a "Robinson Crusoe" portfolio. That is, when his ship ran aground and all his colleagues were lost at sea, Crusoe spent three days salvaging anything from his ship that would be of use in living on his deserted island. His misfortune was severe. But he had enough sense to realise the ship contained items that would be essential for his survival after the shock of his shipwreck.

The stock market offers you a similar opportunity, once the selling abates. You will get an excellent chance to buy Australia's best shares at very low prices.

Dan Denning
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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