That same house sold again this April. Once again the entire neighbourhood went through the house to have a look and while it had been kept up, nothing extra had been added. It was the same, except that this time the property sold for $1.7 million. In four years property prices, at least so far as this particular property was concerned, had risen by forty percent.

There has subsequently been quite a bit of action in selling houses on our street but the most astonishing moment was last week. This was a house that had not been touched for fifty years. To say that it had "original features" only underscores what a derelict mess it was.

And the price: it went for over $1.4 million with four bidders going beyond the $1.2 million level and two going above 1.4.

That this totally astonished all of us in the street is to put our reaction as mildly as possible. That it depressed my son who was trying to think how he would ever be able to buy a house for himself was perfectly understandable. This is an economy with property prices gone mad.

The man who bought the house had just sold up in a more expensive suburb and was locating down, pocketing a net million along the way, although probably half of that will be sunk into renovations. The seller has netted for himself more than a million relative to the price he paid, and was for him on a property he had rented out and not lived in himself. This is, for him, all money in the bank.

And that's the point. It is all money in the bank. There is, according to the press, a difference of opinion between Treasury and the Reserve Bank over interest rates and their proper direction. Treasury cannot see what the rush to raise rates is all about. The economy has barely touched bottom, assuming that it even has. So far as Treasury is concerned, it is madness to be raising rates already when recovery has not truly even begun.

But then there's the RBA. What it sees are house prices rising again and an inflation already becoming entrenched. While the "headline" movement in the CPI was a quite moderate 1.3% across the year, the "underlying" rate the Bank relies on rose by 3.8%, well outside its band of 2-3% per annum over the course of the cycle. And even the headline measure showed an increase of 1.0% for the quarter which of itself is worry enough.

Inflation and What to Do About It

That the economy, particularly the private sector, is still generally moribund is likely. That there is a long way to go before we return to the kinds of momentum we would prefer seems about right. That raising rates right now will slow the economy and delay a return to stronger levels of private sector activity seems almost unanswerable. Yet, with all this liquidity sloshing around, what is a central bank to do?

What makes it worse is that the very aim of the government seems to be to push the private sector out of the way. This is not like an inadvertent error by the Prime Minister to have raised the level of public spending in a panic and therefore to have crowded the private sector out. This seems more deliberate than that, and is in keeping with the notions put forward by the PM in his economically challenged article published in The Monthly at the start of the year in February. At the time, he wrote:

"The magnitude of the crisis and its impact across the world means that minor tweakings of long-established orthodoxies will not do. Two unassailable truths have already been established: that financial markets are not always self-correcting or self-regulating, and that government (nationally and internationally) can never abdicate responsibility for maintaining economic stability. These two truths in themselves destroy new-liberalism's claims to any continuing ideological legitimacy, because they remove the foundations on which the entire neo-liberal system is constructed."

Neo-liberalism, you see, means leaving production decisions to the market to be made by profit-making firms which are trying to work out what consumers would like to buy. This the Prime Minister will not permit given these apparently "unassailable truths". It is his judgement that is going to matter and come what may, he is determined to have the government absorb our national savings for his own purposes rather than for our own.

In a depressing assessment reported in The Australian this week we were told that "the nation's key economic advisory body [the Productivity Commission] says the government has not 'universally applied' its own promise to subject all major infrastructure spending to detailed and transparent cost-benefit analysis." Listed were $66 billion worth of projects that the government does not know, and apparently does not care, whether the money being spent will be repaid in revenues ultimately earned.

I therefore want the RBA to raise rates and keep on raising rates because that may be the only way we are finally going to convince the Prime Minister there are costs to the approach he is taking. Whether raising rates will prevent inflation from taking off is hard to say. It might put a brake on wage movements which are the main feedstock of the inflation process, but governments are the worst industrial relations negotiators so I wouldn't count on them.

But what I am looking for is recognition within the government that they cannot keep pushing their own expenditures upward, crowd out the private sector, and hope to generate real growth. Is there no one within the Government who actually does understand how prosperity comes about? From how they have so far behaved, it really doesn't look that way from here.

The Government is counting on your ignorance to get away with literally destroying billions of dollars of our wealth. If these projects do not repay their costs, they will just make us poorer.

But they will create jobs. And they will lead to a rise in the recorded level of GDP. That other jobs in the private sector will not be created, and that we will actually end up with a lower standard of living because of this tremendous level of public waste, is just how it is.

I now meet people all the time who tell me we had to do something about the Global Financial Crisis. OK I say. Pay the higher interest rates and taxes and be done with it. Such nobility I think! Such self sacrifice! Such idiocy!

These latest expenditures are not being done in the heat of a crisis. They are a matter of deliberate policy. That we let governments direct so much of our resource base to ends of their own choosing is unfortunate. But if we as a community do not know any better, that is just how it is going to be.

Dr. Steven Kates
for The Daily Reckoning Australia

• Why I Would Have Raised the Interest Rates
• The Problem With Artificially Low Interest Rates
• Gold Standard Doubles as the Greenspan Fed Makes Real Interest Rates Negative
• BRIC – Brazil, Russia, India and China Suffer High Rates of Inflation
• Falling Interest Rates and Increasingly Accessible Credit

Maybe it's the end of the dollar carry trade (where speculators sell risk assets). Or maybe not. Whether that little thesis turns out to be correct we'll know in due time.

In the meantime, there are some other things we might learn this week. First up is the TD Securities - Melbourne Institute Inflation Gauge. This will probably show that except for food, fuel, energy, healthcare, and housing, prices in the economy are stable and inflation is contained.

One quick note about this: there is obviously plenty of inflation in the prices you pay every day. But most consumer price indices are rigged to understate inflation, as our colleague David Evans pointed out yesterday in Canberra at the Gold Standard Institute conference in Canberra. Trimmed medians...hedonic adjustments...there's quite a bit of statistical hocus pocus going on.

Inflation is evident if you just follow the money. The returns on wealth (rent, capital gains, income from bonds) are accruing to that group that's benefitted the most from low rates. Dr. Michael Hudson called them the 'financial oligarchy' in his recent trip to Australia. This group has benefitted from inflation in the form of higher asset prices. And meanwhile, the Fed and other central banks have been able to say their policies are not inflationary because consumer prices and, more importantly, wages, aren't moving up.

Duh.

Is it really a surprise that there's no inflation in wages in a world where tens of millions of workers in emerging market economies are willing to do the same work as those in Western economies, but at much lower prices? Wage deflation is the order of the decade. Maybe the century. You generally won't find inflation in consumer prices or wages. But that doesn't mean it isn't there.

So what will the Fed and the Reserve Bank do this week? The RBA meets tomorrow and everyone is expecting another rate rise. The Aussie dollar has all but priced it in. The RBA also puts out its commodity price index week and its always exciting quarterly statement on monetary policy which we just can't wait to pore over for signs of continued credit and debt growth in the Australian economy.

Westpac will also post results this week. If it follows the lead of NAB and ANZ, it will report higher-than-expected bad debts, but claim the bad debt cycle has peaked. Don't be so sure, though. And why not?

Well, over the weekend, CIT Group Inc. (NYSE:CIT), with US$71 billion in assets, filed for the fifth-largest bankruptcy in American history. CIT is the latest victim of the credit crunch, which obviously still isn't over. It's a commercial lender to small businesses that's been unable to refinance its debt. As a non-deposit taking bank holding company, it has to finance asset growth through securitisation and borrowing, both of which are still pretty hard to do these days.

CIT's Chapter 11 allows it to restructure under the protection of the courts. Bondholders might make out okay. The U.S. Treasury, though, has already lost $2.3 billion in TARP money it put into the firm. And the biggest losers are the small businesses who will no longer have financing. That's bad news for the real economy.

As deposit taking institutions, the Big Four Aussie banks are not nearly as vulnerable to this kind of crisis as CIT obviously was. But as we showed last week, Aussie banks still rely on quite a bit of short-term borrowing in the wholesale funds market abroad, borrowing money from foreigners to financing lending here. That's always going to be a weakness.

Hold everything!

Last week we warned that a result of the Fed's low rates is that U.S. banks have stocked up on U.S. Treasury bonds and notes to stabilise their balance sheets. We warned that this could put the banks at risk again, IF the value of those bonds was slashed by market forces. You'd get another bank collateral wipe-out which could, if large enough, wipe out equity. Insolvency becomes an issue again.

But don't underestimate the ability of the bond bubble to go on longer than anyone thinks. The Feds meet this week and will probably not change a thing. Its formal program to buy Treasury bonds and mortgage backed securities with newly created central bank reserves (quantitative easing) can always be extended. So should bond bears like your editor (who agrees that U.S. Treasury bonds are a great short) be wary?

Yes!

The reason is a new regulation passed by Britain's Financial Services Authority which lays out new liquidity rules for bank assets. Rolfe Winkler has the story in his blog. The short version is that the FSA may require banks to own a certain percentage of assets that can quickly be liquidated to raise cash if need be. Lower credit quality assets (junk bonds or lower rated corporate bonds) might not qualify.

What that means - if you read between the lines - is that the only assets which would meet the new liquidity requirements from the FSA are sovereign government bonds. Now maybe this does make bank assets more liquid. But we wouldn't say owning more government bonds makes bank assets any safer, or improves the capital position of the financial sector.

What it DOES do is give the government a way to force new bond issues down the throats of banks. Rather than having to find creditors among the high-saving emerging market nations, governments in the UK and the US would have a captive market in their own financial sector. The banks would gradually gorge themselves on sovereign government debt, provided Moody's or Fitch or Standard and Poor's didn't downgrade the credit ratings of the US and the UK.

It sure looks like another move toward the nationalisation of the financial sector, although in a very clever way. And the banks probably don't mind that much right now. Trading government bonds with new Fed money was a virtually risk-free trade that propped up bank profits in the first half of the year. It's a good trade.

But in the bigger picture, as Nial Ferguson and Ken Rogoff mentioned this weekend, this means that the financial crisis may soon become a sovereign debt crisis. So far, the liabilities of financial firms have been transferred to the public sector balance sheet. But this has not solved the problem. It's merely moved it to a larger stage on which it must play out.

As we mentioned in our remarks yesterday at the gold show, we believe this marks the beginning of the end of the Super Cycle in paper money. A sovereign debt crisis is the same as saying that the funding model for the fiscal welfare state is broken. Only in this case, there is no organisation large enough to bail out the fiscal welfare state. What does that mean? More on the consequences, and the opportunities tomorrow.

"This is the first time I've been in Canberra," we began our remarks yesterday. "I spent most of last night trying to figure out what it reminded me of. And then it came to me. It reminded me of Washington D.C., and not in a good way. I spent four years in college living in DC. Both cities make you feel like you've stepped onto a very orderly and sterile brothel."

Dan Denning
for The Daily Reckoning Australia

• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Hyperinflation and the Dollar’s Monetary Destiny
• Everyone We Know Expects a Fairly Quick Up-move in Inflation
• The Asian Banks Have Finally Been Heard From
• Australia to Borrow as Much as $300 billion

Much will be revealed this week in the Aussie market, although a lot will probably remain obscure too. Producer price data for the September quarter comes out from the Australian Bureau of Statistics. Inflation anyone? Maybe not in wages. But certainly in raw materials (energy).

And speaking of inflation, the Housing Industry Association will report new homes sales data for September later this week too. What do you reckon it will show? Our prediction: how prices in Australia are outrageous and getting more so with each passing month, as the banks double down on home lending.

You may even see a move in the Aussie gold price this week. It could come if the U.S. dollar pulls itself together for a bit of a rally, as we're expecting. But the other reason Aussie gold may go up is a small item on the front pages of today's Australian Financial Review. "Big Banks gear up to lend again," reports the AFR. Uh oh.

No one's been too terribly worried about consumer price inflation lately, mostly because it's been masked - until recently - by cheaper oil prices. Of course the biggest factor affecting consumer price inflation is the growth in bank credit. The RBA reports on that later this week. But bank lending is the main engine for new money creation in the economy...and new money creation is the main engine for inflation.

"The Big Four banks are keen to lend more aggressively to large businesses as the economy recovers and competition for assets intensifies, in a development that is likely to drive down corporate borrowing costs," Katja Buhrer writes. "The major banks are seeking to take advantage of surplus capital and improving corporate growth prospects."

Hang on! Surplus capital? Just last week we were under the impression that Aussie banks were having to import capital from foreign lenders in order to fuel the housing bubble. Now there's surplus capital? And now the banks are eager to loan it out and build up the asset side of the balance sheet again?

So much for deleveraging in the financial economy! This sounds like re-leveraging. It also sounds like exactly the sort of thing - a fresh new wave of bank lending into the real economy - that could trigger much larger inflation. This is the sort of thing the RBA is trying to prevent by raising rates. But if banks start expanding the asset to capital ratio again, watch out! You could see higher Aussie interest rates AND a higher Aussie gold price.

"West Africa beckons as Aussies go for gold," reports Barry Fitzgerald in today's Brisbane Times. This answers a basic investment question: which Aussie gold producers benefit most from a rising gold price and a strong Aussie dollar? ASX-listed firms with greenfield West African gold assets generally have their costs in U.S. dollars. That's a big advantage over domestic gold producers.

Dan Denning
for The Daily Reckoning Australia

• RBA Rate Cut Does Little to Unlock Credit Market
• Global Credit Shortage is Over According to European Central Bank
• Australian Recession in the Works? Ask the Sharemarket
• Foreign Investment in Australia, How Much is Too Much?
• Banks or BHP?

Which shares win and which shares lose the stronger the Aussie dollar gets? Slipstream Trader Murray Dawes has been on the case over the last week, looking for other tradeable trends in the ASX 200. The stronger Aussie affects the costs and export earnings of big domestic companies. That makes it a catalyst for trading ideas. And the size of the moves in these larger capitalisation stocks is kind of surprising. But for it to be profitable, you have to first sort out who wins and who loses.

GoldmanSachs had a crack at it last week. According to today's Australian, "The biggest winners include Qantas and Virgin Blue (lower fuel costs and strengthening outbound travel), Boral (lower offshore debt costs), condom and glove maker Ansell, apparel importer Pacific Brands, diversified industrial Alesco and waste manager and car importer Transpacific."

And the possible losers? The report says they will be, "Defensive stocks with an offshore earnings skew and which also are not exposed to this global growth. These include CSL, Cochlear, Resmed, Ramsay Healthcare and QBE Insurances. GSJBW cites BlueScope, Paperlinx, Caltex, Incitec Pivot and Aristocrat Leisure as other losers, but notes currency is only one of many variables affecting earnings."

We reckon it's all a bit of tempest in a tea cup. Corporate earnings have been inflated by the credit bubble and funny accounting for the last 50 years. A quarter or two of noise about earnings is not the big story, even if the currency move is substantial. There are really only two questions that matter.

The first is whether or not shares as an asset class are a good idea right now. That's a huge debate. But part of the answer lies in your views on inflation. As we argued here in July, stocks are definitely better than bonds when inflation is the big threat. The Reserve Bank seems to think that is the case. So make of it what you will.

What we make of it is that dividends used to account for a much larger percentage of your total return in stocks than they have in the last twenty years. Times change. There's no rule that says the future has to be just like the past. But if stocks beat inflation, should you invest in stocks for income or capital appreciation? That's the second question.

Aussie investors haven't usually had to make that choice. Bank stocks, for example, provide dividends and capital growth. But today, we reckon that cash flows are reverting back to the mean growth rate, which is obviously lower in a world that's deleveraging and relying less on credit to fuel business and consumer spending. Rather than being inflated by consumer demand (supported by credit) we predict slower rates of organic growth, across the board. This rewards investors who pay attention to how a company generates its earnings.

Kris Sayce in his work at the Australian Wealth Gameplan, reckons that now is a good time to add dividends to the mix to beat both inflation and the trend toward smaller growth in corporate cash flows. Practically, this means investing in businesses than can increase earnings in good times and bad and can do so without high capital costs which force them to borrow money. They return the excess cash to shareholders.

In cash flow growth is constrained by less credit in the system, you also want to own businesses with leverage to a rising commodity or an emerging market. This works out pretty well for a lot of Aussie firms.

Take energy. Chevron announced another major gas find off the coast of Western Australia this weekend. Chevron's $21 billion investment in the Gorgon project in WA is already the company's single-largest investment anywhere in the world, according to the Australian Financial Review.

And why? Chevron reckons LNG from WA is going to be the carbon dioxide friendly fuel for Asia's future. True, the fixed capital costs for producing off-shore LNG are high. But the whole industry is certainly leveraged to higher energy prices, which ought to translate into higher earnings for Chevron. Your risk is that oil prices crash and take LNG prices with them, upsetting the whole applecart.

So how does this all fit into an investment strategy for a world where there is no clear winner between inflation and deflation, where there is still massive leverage in the financial system, and where public finance is creating huge long-term deficits to replace (mistakenly) the missing demand from households that are beginning to live beneath their means? Good question!

You can trade the blue-chips in their ranges based on currency exposure or leverage to commodity prices. This is what Murray is up to at Slipstream. Or you can just chuck a few market-tracking ETFs in your portfolio and forget about it, in which case you can read the DR for fun and laughs rather than investment ideas. But you can also afford to be a bit more selective, and should probably consider doing just that. Why?

If the Credit Depression is going to take a bite out of corporate cash flows for years to come, focus on that risk and avoid the stocks most vulnerable to it (leveraged players in property, mortgage lenders, and banks.) But also build yourself, as Nassim Taleb says, a portfolio of risk's that's built for a world of extremes (Extremistan!).

Taleb says you want a maximum amount of zero-risk securities. Whether that is cash, bonds, dividend-paying stocks, property, or gold bullion (not really a security) is where the debate lies. He also recommends, though, that you have a small amount of risk capital in maximum risk securities. Which ones?

You want securities where you'll find low-probability but high-value events that can move the share price. This is not banking. In banking, all the low-probability (or frequency) events tend to have catastrophic consequences when they do occur. Russia defaults. The subprime market blows up. You have maximum risk. The probability is remote, but the magnitude of an occurrence is a portfolio destroyer.

But in other areas - small cap stocks, oil and precious metals exploration and production companies, for example - the low probability events are almost always high magnitude events in a positive way. You cure baldness or impotence. You find gold or oil. You invent the iPod or Google.

In these businesses, cash flows and earnings are above trend for a three to four year period in which the share price trades at a steep premium, factoring in future growth. This is the sweetest of sweet spots for growth investors. But to taste it, you have to also have a taste for risk.

That's why it's worth being in the market in a small amount of low-probability but high-magnitude type companies. You want a portfolio of risks like that. And it doesn't have to be a big one to be worth it, or jeopardise an otherwise risk-averse strategy. In fact, we reckon that this strategy is going to generate far better returns over the next ten years that the conventional buy-and-hold blue chips through your super strategy.

Dan Denning
for The Daily Reckoning Australia

• Note to Australia: Buy Resources, Not Banks
• The Problem With a Well-Diversified Portfolio
• Gone Fishin’ Investment Strategy
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Banks or BHP?

I am not normally a fan of using rates to control economic activity but on this occasion it was only partly about the economics narrowly defined and a good deal more about providing a warning to the loose fiscal cannons in charge of managing our economy. The rate increase could not have come soon enough to suit me.

Do I know why the RBA raised rates? No. Am I privy to the discussions of the RBA Board? No again. But I do know this. I do know why I would have raised rates, and would keep on raising them until the Government gets the message. That I do know.

The data below are from the most recent set of National Accounts. The data, which I discussed in my previous posting, show the level of National Net Saving and the Saving Ratio. Both are at extraordinarily low levels.

The figures make it unmistakeable that there has been a collapse in the level of national savings available to all users across the economy. These are investable funds that are potentially available for those who would wish to increase our capital base by borrowing the incomes earned by others for use in projects of their own. The funds available have not only cascaded downwards, falling by half over the past year, but the rate of decline has even been accelerating.

This is an outcome that would worry any central banker worth his salt. Depleting our savings in such a savage way will have left us even less able to regenerate growth than we were twelve months before when the stimulus spending began.

Parenthetically, it might be noted that the only justification for a Keynesian stimulus - at least if there were any consistency between the Keynesian models that are taught and the policies everyone is attempting to pursue - is that there are unused saving that need to be soaked up in higher levels of public spending.

Saving in a Keynesian model creates damage because it reduces the level of spending. Since in a Keynesian model we can't count on investment rising to fill the expenditure void created by our savings, it is the government which must come to the rescue to spend our way to prosperity. It is increased public expenditure and higher deficits that move the economy out of recession.

Well, how much nonsense is that! The government, rather than deploying savings no one else is willing to spend, is spending our savings before anyone else has a chance to get at these savings themselves.

There is then the savings ratio, which the ABS defines as "the ratio of national net saving to national net disposable income." The data show that in the latest quarter, the ratio has not just fallen, it has become negative. Individuals in aggregate are taking money from their savings and using it to pay the bills. Expenditures are rising faster than disposable incomes.

That interest rates must rise in such circumstances is beyond question. They will rise with or without the RBA, and in fact, aside from mortgage rates, already have. Partly the interest rate number has gone up, and partly there has been a restriction on the availability of credit. But up interest rates have gone and for good reason. The RBA is mostly just catching up with the market.

There are then the data from the RBA showing the growth rate in Business Credit between March and August this year. No economy entering a serious growth phase has numbers anything like that.

In the last month for which there are data, in August 2009, there was again a fall in business credit and over the year the level of business credit has fallen by 2.2%.

This is almost the classic case of crowding out. Others are getting to these funds sooner and more cheaply than business. Government spending has replaced business spending. The government stimulus is thus not only wasteful almost down to the last dollar spent, but is preventing the private sector from having access to the funds it needs to invest and employ.

The political side to the rise in interest rates therefore strikes me as a warning shot across the bow of the government. It is a statement from someone worried about the way in which we are ploughing our productive potential into the ground with the certainty that in a year or two we will have an immense debt and nothing to show for it.

Raising rates may begin the process of sobering up those who have been wasting our resources hand over fist and remind them that there is a price to pay and the debt is starting to be called in now.

And let me add one last point. It is said that the rise in interest rates is working in the opposite direction from the increases in public spending. Higher rates will slow the economy while higher public spending will increase it. There is therefore an inconsistency and contradiction in public policy.

This would be true only if there actually were some kind of stimulating effect of higher public spending. Since such spending is a negative, since it only acts to weaken an economy and slow it down, there is nothing whatsoever contradictory about using higher rates of interest as public spending goes up.

I am, in fact, inferring the highest motives to the Governor of the RBA who may himself actually see only negative implications in the stimulus and is trying to get the government firstly to stop spending, and then, if possible, to roll back what planned levels of spending has not yet taken place.

But as for this rise in rates being a contradiction, there is none at all. Savings are being plundered by the government, and if we are going to find our way to a genuine recovery, the government's hands must first be pried off the savings of the nation. A really sharp rap on the knuckles may be the only way.

Dr. Steven Kates
for The Daily Reckoning Australia

• The Dead Weight Cost of the Stimulus
• Dr. Woody Bock’s Essay: The Future Evolution of the Debt-to-GDP Ratio
• Consumer Spending Rises
• Aussie Dollar is Crushing Long-time Rivals Like the Pound and the U.S. Dollar
• Saving Money, Not Spending it, is the Key to Getting Wealthier

On 21 September I provided testimony to the Senate Economics References Committee on the damage done by the government's "stimulus" package. The submission was broken into five separate sections.

1. The state of the national economy where it was demonstrated that the Australian economy has been and is in recession. Even using the "technical definition", the actions of the Government have not prevented the economy from entering recession.
2. The impossibility of quantifying the effect of the stimulus showing that conclusions based on projections from a Keynesian model cannot be used to demonstrate that the economy would have been worse off had no Keynesian stimulus been applied. To think that a Keynesian model can substantiate any Keynesian claim when the economy continues to flounder is merely circular reasoning and based on no serious evidence.
3. The harm done by the stimulus which includes:
   • noting that there is no justification for the introduction of a stimulus other than its effects on employment whose effects have been minimal at best
   • the distortions in the structure of production which occur as a result of the stimulus which directs the economy into unproductive activities
   • the loss in real economic growth because the stimulus measures have competed resources way from productive enterprises
   • a loss in long-term economic growth which will depress the rise in real incomes and lower living standards
   • the effect on interest rates which have remained higher than they otherwise would have been and will rise sooner than they otherwise needed to have done
   • the effect on future taxation which will need to rise by prodigious amounts if the debts that have been taken on are to be repaid
   • the potential effect on inflation which may become an important medium-term economic issue as the recovery gathers some momentum.
4. The fundamental structural flaws in Keynesian economic theory which wrongly argues that increases in public spending and budget deficits are capable of generating economic growth even when the money spent is spent on producing goods whose value is far below their costs of production.
5. A discussion of the theory of the cycle where it was noted that economies are subject to alternating periods of growth and periods of recession. The panic that greeted the downturn both here and elsewhere were massively disproportionate to the actual dimensions of the problems, even assuming that a stimulus package was the right approach, which it isn't.

The full submission runs to 27 pages, but I will just note a couple of the specifics raised. The first of these is to point out that the economy has not only been in recession, but using the ABS-preferred trend data, the downturn even matches the definition of a "technical" recession by having contracted in two consecutive quarters.

The movement in the September quarter 2008 was negligible but unquestionably negative. In the December quarter 2008 the fall was somewhat larger but again negative. Thus using even the "technical" definition, on the best measure we have of the movements in GDP, the economy contracted for two consecutive quarters.

But it should not matter whether there were actually two consecutive quarters of falling GDP for us to declare that the Australian economy is in recession. If across a four quarter period, the growth rate has been 0.3%, then the economy is in recession. To pretend otherwise is simply to deny a reality that really cannot be denied.

The phenomenal fall in the level of national saving is also quite disturbing. Savings have diminished to half the level they were at a year before. In the June quarter 2009, there was a fall of one-third in just that period alone.

Moreover, in June 2009, the saving ratio has descended into negative territory, being recorded at -0.4. The notion that the stimulus has been tucked away into additional savings is belied by these figures.

The notion that was always at the core of the Keynesian model, that recessions are due to over-saving, is clearly nonsense. But without that bit of cover for the actions taken, where is the theoretical justification for spending money and deficit finance.

The Keynesian model, for those who have not studied economics, argued that recessions were caused by too much saving relative to the willingness of investors to invest. The Government was then required to make up the difference by increasing its own expenditures to soak those savings up.

The data, however, do not indicate any such problem. If there is a problem, it lies with not enough saving which makes the Government's pursuit of our accumulated saving through its expenditure package even more difficult to justify. It is not hard to see when one looks at these figures why the RBA is itching to raise rates as soon as possible. It is why rates are rising already with or without the cover provided by the RBA. The potential for an inflationary spiral is not low.

I also pointed out to the Committee that the cost per job saved has been in the vicinity of one and a half million dollars each, based on the assumption that had there been no stimulus, the unemployment rate would have risen to around 6.1% (and here I am giving the stimulus the benefit of the doubt).

But to give you an easy access to the orders of magnitude involved in such immense levels of spending, I will just point out that we have spent $43 billion on the stimulus, for which there is real reason to believe we will not get a single dollar of economic return for the money spent. In times past the words we used to refer to a figures such as 43 billion was to say 43,000 millions. If we have created a net addition of 43,000 jobs for $43,000 million, then each of those additional jobs would have come with a price tag of around $1,000,000 each.

It's all very well to say that something had to be done. It is something else again to say that we have to spend one million dollars for each additional job saved. It would not have made good economic sense at one tenth the cost, but this is totally beyond reason.

We have poured four percent of our national output into projects that cannot generate in any possible way an increased productivity that allows the debt created to be repaid from the projects themselves. It is all just a dead weight cost.

I will finish with something that was picked up from my testimony by the AAP which I did not even know I had said it until I read it. "The use of Keynesian economics has been on of the great catastrophes for economic theory in the West". Just how true this is I fear we are all about to find out.

Dr. Steven Kates
for The Daily Reckoning Australia

• Why I Would Have Raised the Interest Rates
• Australia Might Avoid the Technical Definition of Recession
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package
• Economists Agreed the Stimulus Was Working and the Recession Was Coming to an End
• Government Preparing Another Stimulus

The "drugs" he's talking about are antibiotics, and your editor choked down the last of them this morning. Hopefully, we'll be less infected from now on. So we're going to push on and hope our mind clears up enough to figure out if the easing of one emergency can actually cause another.

We're talking about the total meltdown of the Aussie housing market, which is, after all, just a matter of time. Next Wednesday will see the release of the national accounts for June. Those figures will probably show the economy being less bad than previously expected. That might lead to the end of the "emergency setting" of the RBA cash rate at 3%, which will precipitate the decline and fall of ridiculously high Australian house prices (although this could be good for equities).

Hang on a second though. The GDP numbers will be tough to read because they're distorted by government stimulus spending, which spits in the soup of the economy. In other words, it'll be hard to tell at a glance how well the economy is really travelling on its own momentum versus how much of it is Kevin Rudd, Lindsay Tanner, and Wayne Swan with their hands on the boot of the economy pushing it down the road. Will the engine catch or sputter?

Right now, it's coughing a bit. Figures yesterday from the Australian Bureau of Statistics showed that business investment was up 3.3% in the June quarter. Most of the increase came from a 5.3% rise in investment in machinery, plant and equipment. It looks like businesses are taking advantage of Federal tax break to front-load future investment now. Whether they really need it now, who knows?

For instance, we received this note yesterday from a reader who paints a different picture:

Good Afternoon. I am a subscriber to your Daily Reckoning newsletter and thank you for this great service. I subscribe to the Grays online website for their daily online auctions and lately I have noticed a substantial increase in the amount of capital equipment auctions and often for equipment that are still under service agreement.

M.

You're welcome M. And who knew it was a bull market in forklifts!? Maybe it's not as surprising as you first think. You'd need a forklift to carry away the amount of BS being shovelled out by free-spending Keynesian politicians and the brainless economists who give them covering fire in the spineless media.

But we'll have to take it is a given that the June quarter GDP figures are distorted in a way that makes it nearly impossible to find out how well the economy is doing. That uncertainty (government intervention diminishes the quality of our knowledge because it interferes with price signals) may prevent the RBA from raising the cash rate. Or it may not. We won't know until the bank does something. Or nothing.

We've been saying all along, though, that the biggest threat to Aussie housing prices is the beginning of the tightening cycle in interest rates. The Aussie dollar was up overnight near 84 cents versus the greenback, partially in anticipation of the growing interest rate differential between the two countries. The U.S. dollar also fell against oil, which took a dip below US$70 on the front-month crude futures contract and then decided it liked it back above $70, which is just where it went.

You can take your pick of reasons for rising Aussie dollar strength...growing economy, yield difference versus the greenback...commodity currency benefitting from secular decline of the USD. But after you pick, you have to ask the next question: will the RBA raise rates because the economy here is healing? If it does, it will send the Aussie higher. But what will it do to house prices?

If you're in the real estate industry, you'll say "Nothing! House prices go up in all markets at all times regardless." But if you have a brain and use it from time to time, you would have to at least entertain the possibility that climbing interest rates and the end of the first home buyers grant spell real trouble for the housing market and the marginal buyers who support it.

The housing market requires a constant stream of new buyers and a fresh supply of credit to keep demand for mortgage finance up. That's the only way for new buyers to bridge the gap between stupidly high median house prices and real wages that are not keeping up with home price inflation. Yet as we pointed out yesterday, the government-backed mortgage finance operations are nearing the legislative limit on funding. Something is going to have to give.

Our guess is that it will be house prices. But you know that already since we've written in before. And besides, our main beat here is not property, but stocks. And it's possible stocks - on the back of more energy deals and continue Chinese demand (see Baosteel's prospective $300 million investment in coal and iron ore hopeful Aquila today) - could do a runner and sprint ahead of the property market (and bank stocks and listed property trusts at the end of their own little nice dead-cat bounce).

Don't forget gold, either. It's never far from our mind, nor our heart. Obviously the stronger Aussie dollar is bearish for Aussie gold bullion prices. On the share market side of the gold market, however, gold and explorers and producers may benefit from increased demand for ye olden yellow metal. Investment demand for gold stocks as U.S. dollar hedge is back.

Reuters is reporting that on Wednesday, ETF Securities, one of the backs of a gold metal exchange traded fund, saw its largest one-day inflow ever. The funds, "holdings jumped 7% or 211,500 ounces to 3.190 million ounces of bullion on Tuesday, from 2.978 million ounces the day before." In the last week, the fund's inflows are up 18%. Yowza.

And for those of you who began following (and suffering along with us) on the rare earth metals story, a new development today. Our story first began in June of last year when, writing a guest article at the Australian Small Cap Investigator, we tipped two Aussie rare earths shares. One was a producer, the other prospective.

Both got shellacked in the credit crunch, especially the more mature company that ran into a financing problem. But the underlying case for non-Chinese suppliers of some of the most essential and expensive elements for the modern technology and aerospace industries was still strong. Still is today, in fact. Even stronger, apparently.

The Times of London is reporting that China is ready to slap an export ban on rare earths in order to choke off any non-Chinese consumers of the elements. This affects Japanese, American, German, and South Korean companies to name a few. China has systematically and quite cleverly made itself the key global supplier of these elements. So what now?

For the consumers of rare earths, we have no idea. They are at the mercy of a limited supply. There's no such thing as just in time lanthanides production. But for punters and strategic investors who have their eye on well-shaped rare earth ore bodies in Australia, or owned abroad by Aussie-listed companies, the story is playing out quite nicely, after a few bumps and bruises at the start.

Incidentally, ASI editor Kris Sayce is having lunch with the honchos of one of the rare earths shares he follows in the ASI portfolio. It's not until the second week of September. But we're keen to read his next report on the subject.

The China strategy on rare earths is still playing out. But you see another strategy playing out in solar cells. Today's Australian reports that Chinese solar cell producers are selling their product into the global market at below the cost of production in order to gain market share and drive even low-cost producers in competitor countries out of business. Can it last?

You can sell your product below the cost of production for awhile, especially if the national government is subsidising the endeavour as part of a long-rate market strategy to own the bulk of the world's manufacturing capacity. And for consumers - provided the product quality is good - it means low prices for awhile. But it's also an unfair trade practice that could be taken up other countries with the World Trade Organisation, prior to resorting to less legalistic forms of conflict resolution.

Your editor got a note from an old friend who is running for Congress in the States. He asked, "With this current crisis and our long-term prospects bleak, why not move toward a more protectionist trade stance? Economically, what are the repercussions of attempting to level the playing field between America and countries that systematically under cut our workforce and product base? If Japan and china consistently strive to under bid is in all areas, why not close the gap at home through trade policies? Are we afraid they will call our loans?"

Our answer on Monday. Until then...we're pleased to let you know our discussion of debt and what it does to a country - its economy, housing market, and stock market - is now available on DVD with a written transcript. There was quite a bit of discussion the Aussie property market that night. So if you're interested in property, you'll want to have a look.

Dan Denning
for The Daily Reckoning Australia

• Aussie Housing Market Actually Leads the U.S. by Three Years
• House Prices Down and Aussie Market Enters Second Wave of Rebound Rally
• Good Month for Aussie Stocks, While U.S. Stocks Fell to Close the Quarter
• Australian Housing Market Getting Stronger Despite Fear of Inflation
• Most People Think a Rising Housing Market Makes Them Richer

Lesson? There's always an unseen or unforseen consequence to any action. In this case, the good news for NAB is that it's rebuilding its balance sheet with equity capital. That's a good alternative when the global cost of capital is going up (mostly because government bond auctions are hoovering up so much private capital).

The bad news is that existing shareholders took a hit on their shares when NAB discounted the offering to the current share price. It probably had to do this to incentivise buyers. But that was the hidden cost, and it was born by existing shareholders. And in any event, we're still not convinced that capital raised to buffer against further loan losses is the kind of event a shareholder would be bullish about.

Did you know there are already entrepreneurs who plan to build the infrastructure to recharge electric cars in Australia? Maybe it's wacky. Maybe it's ahead of its time. Maybe it's creative destruction at work!

Yesterday's Age reports that, "Shai Agassi is the charismatic entrepreneur, electric-car evangelist and founder of Better Place, a US-based company that plans to roll out the infrastructure necessary to recharge electric cars at home, at work and at battery-swap roadside stations.

"Speaking in Melbourne, he said Australia could become the modern equivalent of oil-rich Saudi Arabia if it quickly switched to manufacturing electric vehicles and lithium batteries. 'A billion electric car batteries will need to be made - that is the biggest industrial opportunity in the world today,' he said while giving the inaugural Deakins 2009 Eco-Innovation lecture. 'Australia can pick whether to be an exporter of iron ore, phosphate and lithium, or of kilometres [in the form of batteries].'"

An exporter of kilometres? Hmm. It does sound wacky. But having recently written on an Aussie lithium producer in Diggers and Drillers, we'd agree with Agassi that a lot of electric car batteries are going to be built in China and Japan in the next twenty years. And they're going to need a lot of lithium carbonate.

By the way, if you're going to recharge an electric car battery, you're going to need electricity to do it. Ziggy Switkowski says the wind and solar industry is a "cottage industry" that cannot meet the energy requirements of an industrial economy like Australia's. "There is no other alternative but to go nuclear," he says.

To be fair, Switkowski (like everyone) is talking his own book. He's the head of the Australian Nuclear Science and Technology Organisation. His job is to talk up nuclear. But we think he raises a fair point that hasn't really been debated in earnest in Australia: will renewable sources deliver the Australian economy the energy it needs to grow or do you need nuclear energy in the mix too?

Here's a shocker: there is no inflation in Australia because men's underwear is cheap.

We somehow missed that story in the papers earlier in the week. But sure enough, Thursday's Age reports that, "Sharp falls in the prices of men's underwear, fruit, vegetables, milk and bank charges helped offset big rises in the prices of women's underwear, hospital services, real estate and petrol."

The data, courtesy of the Australian Bureau of Statistics-suggest that if you wear jocks, eat apples and drink milk, your cost of living is going down, even if you get sick, buy property, drive a car, and sometimes wear women's underwear. That's probably good news for somebody out there. But is the cost of living in Australia really doing down?

Not if you ask the RBA! The Reserve Bank of Australia publishes regular inflation data. That data includes the "trimmed mean" measure of inflation. This measure (defined below) excludes volatile changes in certain consumer prices to "smooth out" the noise in the data set. The ABS also publishes this data, which you can find here on page 27 (analytical series 10).

What both data sets show is that underlying inflation in Australia is up about 3.6% in the last twelve months. That's outside the RBA's comfort zone of annual inflation/systematic erosion of your savings and purchasing power of between 2-3%. So are the statistics lying?

Well, we wouldn't go so far as to suggest that government statistics may be deliberately understating the rate of inflation. That could never happen. But it does show you that statistics can often be abused to contradict common sense.

Common sense tells you the cost of living is going up, despite the really great deals you can get on men's underwear. This is why there's such a large difference between the headline rate of inflation-which measures consumer price growth across around 70 different categories-and underlying core inflation-which measures price growth in core consumer purchases and weights them accordingly.

It does have the feel of statistical hocus pocus about it sometimes. RBA man Tony Richards explained the methodology here in 2006. The key part of his speech was this: "[Trimmed means} 'trimmed' means in the sense that they are the mean or average price change for the CPI basket after taking away, or 'trimming', the more extreme price changes in any period."

He added that, "Trimmed mean measures exclude - or more correctly down-weight - the impact of items based on whether or not they appear to be outliers in the period in question. These measures represent an attempt to estimate the central part of the distribution of price changes, and provide a measure of inflation that is not excessively affected by large price changes - either increases or decreases - in individual items."

It's a little weird to measure inflation by excluding the things that are actually changing in price. You'd think that would be important. But the RBA is trying to weigh which price increase matter more: underwear or petrol. It's probably best to keep it simple and say that when money and credit growth increase and bank reserves grow, the money supply growth (inflation) leads to rising prices.

We move on to superannuation and a pretty significant discussion of a change in corporate cash flows and how investors value them. Some financial planners and folks in the super industry have written in this week saying that we're being unfair to the industry by claiming the interests of planners and funs are not aligned with the interest of investors.

Suit yourself. We never said there weren't honest financial planners there. And by definition, not all actively managed funds are average. Some are better! Some are worse!

The point that's worth debating is whether there is a bias in the funds industry toward putting Aussie investors in common stocks no matter what's going on in the market-and especially into products that financial planners get paid commissions on, whether they suit the needs, goals, and risk tolerance of their clients.

This probably sounds stupid. The purpose of the funds management industry IS to put people into common stocks. But we think this reveals the divergence of interests between investors and the funds industry. There are certain times in financial markets where you need to ask yourself if you should be buying what they are selling-or at least remember that they are always selling.

This thought was prompted by a study quoted in yesterday's Australian Financial Review that shows the average balanced retirement fund was down by 13% in the year ended in June. It was the worst annual performance on record, according to research house Chant West. That performance is pictured below.

The upside-according to the data-is that over the last fifteen years, the median annualised return for growth funds was 6.9%. It peaked around 13% early 2000 and late 2007 before declining to around four percent each time. Chant reckons annual CPI increased by 4.2% over the same period. So all up, even after the shocker of last year, the investor who got into super fifteen years ago is still beating inflation and in the black.

This, of course, argues for buying and holding stocks and allocating the bulk of your assets (despite your age) to growth or balanced growth. That puts 40-60% of your assets in growth stocks. And THAT is the figure we think super investors should be asking themselves about.

If it's a bear market in stocks as an asset class, then being that heavily weighted in common stocks for your crucial capital-accumulating/income-producing years is going to be a big mistake. Remember that upwards of 90% of your total return in any investment comes from being in the right asset class, not single stock selection.

The question of how you allocate your assets in super, then, is what we're banging on about. Kris Sayce is banging on about it too. And in fact, he's banging on about it so much we've decided to publish a new newsletter on the subject of superannuation, income generation, and controlling your risk. Look for an announcement on that in your inbox later today!

For now, we just think it's a question you should be actively asking. Whether or not you actively manage your investments is up to you. But even in the equity market, we think it's well worth examining the old saw that you should just buy and hold over time because stocks go up in the long run it's too hard to time the market.

We have our resident Frenchman and technical analyst Gabriel Andre hard at work beta testing a system based on technical variables and charting. The goal of the system is to see if you can increase your returns in Blue Chip stocks by selling when they break technical support and buying back when the indicators suggest.

Granted, this is not the sort of thing for everyone. But in its latest monthly update, the ASX indicated that while volatility (as measured by the VIX) died down in June on the S&P 500, it stayed elevated in Australia. The average share market swing was 1.2% in the month.

That kind of volatility comes when there's uncertainty. And that kind of uncertainty comes when there's a changing in the structure of how large export commodities are priced (iron ore) and when investors aren't sure how strong demand for Aussie resources will be in the next few years. Throw in lingering doubts over how well-capitalised the banking sector is and how much capital the country may have to import and you have a scenario where market volatility could remain much higher for a lot longer.

Or, if you want to put super returns and share market volatility in perspective, you could argue that volatility is going to remain high in stocks because there's a huge debate over whether the historic equity premium in stocks is collapsing.

The equity premium is the extra return from stocks compared to bonds or cash that investors are willing to pay for. They take on a bit more risk. But in exchange for that they get extra return, the equity premium.

The argument for a collapse in the equity premium is made by some folks we quoted a few weeks back regarding the historic importance of dividends to the total return of your stock portfolio. The book is called Triumph of the Optimists by Elroy Dimson, Paul Marsh and Mike Staunton. And in it, the authors argue that over the last 100 years, corporate cash flows have grown faster in the last fifty years than in the previous fifty years.

As a result of the visible and tantalisingly large corporate cash flows, investors have been happy to bid up stocks (the rising equity premium) in order to capture a piece of those future cash flows. Hence rising P/E ratios (especially during the tech boom) and falling average dividend yields for stocks.

But if the authors are right and corporate cash flows revert to trend in the next fifty years, then investors are already paying too much for earnings that won't materialise. Presto. Change-o. You can expect a falling equity premium as corporate cash flows revert to the mean growth rate.

And why would corporate cash flows revert to the growth rate they had in the first half of the 20th century? Why the credit depression of course! That is, you could argue (quite successfully we think) that the increase in corporate cash flows over the second half of the twentieth century was largely influenced by the growth in global money supply.

Low interest rates and money and credit growth (first in the Western world and lately in China) generated a ton of economic activity. Some of it was legitimate, as the global population grew in size and per capita wealth. It made led first to huge profit margins for American manufacturers. But later, it led to the migration of productive capacity to Asia and a structural decline in Western wages.

What's more, some of the economic activity generated in the modern world of fiat money-particularly in inflationary periods-was of a lot more dubious value. It wasted capital in the sense that it did not produce incoming producing assets for the future that investors could own or capitalise.

But ALL the economic activity generated by money and credit growth found its way into higher corporate cash flows, at least for a pretty long period. Investors then bid up the value of those cash flows, resulting in the equity premium blowing out relative to bonds and cash.

If all that is changing now, it is a very big change and has serious consequences for your wealth-management and retirement plans. One obvious question is if the equity premium returns to trend, does that favour cash or bonds? Will investors prefer those assets more as they prefer stock less?

Our answer is a definite maybe! For many reasons, we would not shift into bonds, especially government bonds. We reckon either inflation or devaluation will eat way your capital there. On the other hand, you know what we think about gold!

But regarding stocks, we reckon switched-on investors will begin demanding stocks that do pay dividends over and above the interest rate on government bonds. Of course for a company to do that its cash flow has to be predictable and growing and not overly-leveraged or capital intensive. Finding those companies is what Kris is up to in his new letter.

But it's also possible that outside the stock market you may simply see the formation a tangible asset premium or a "commodities premium." As cash flows dry up for heavily leveraged business models in the financial economy, they will begin flowing for producers of tangible assets that play a part in the industrial growth of the developing world. Investors who can value those cash flows and time their entry into the stocks-accounting for volatility in commodity prices-may do very well.

That's the idea anyway. And if that idea is correct, it means you may be able to profit in the coming years from a share portfolio made up of companies with growing cash flows from the resource-intensive growth of China. While cash-flows shrink at Macquarie, they may increase at Rio, BHP, and a whole universe of smaller Aussie miners.

But this is such an theoretical discussion-and so far removed from the cliché of buy and hold investing in your super-that we'd expect to see a great deal of volatility in shares as this debate progresses. The volatility is really a result of people not knowing what the future holds, and valuing the present value of future cash flows very differently.

And it could last awhile. The bull market in stocks lasted twenty years. The bear market has already lasted eight. It could last another ten-especially if the authorities actively prevent the liquidation of bad debts and write offs in bank collateral. It will be a long, drawn-out, Zombie-like, Japanese demise. And it means regular volatility on share markets.

We found some support for this observation here. It was a study published in the Journal of Financial Research in 2004 called, "Analysing stock market volatility using extreme-day measures." The study's author Jack Wilson says that the study finds argues that:

Volatility is higher during bear markets. The intuition is that periods of increased uncertainty influence the market in two ways. First, equity value declines reflect higher risk associated with increased uncertainty. Second, increased uncertainty is associated with increased volatility as the market receives information. Veronsi (1999) provides a model that explains how rational investors react to news more quickly in times of greater uncertainty, which increases stock price volatility. Our evidence supports this view.

We'd argue that rational investors are a figment of the scientist's imagination. But it does make sense that in periods of increased uncertainty - and a historic change in the equity premium would definitely produce a lot of uncertainty - investors are going to behave in a highly unpredictable way.

At the very least, this suggests that more active management of your investments and your asset allocation is a good idea. We probably could have just wrote that and left it and that. But most people are reluctant to get more involved in managing their own money. It could cost them in the coming years.

On the other hand, it doesn't take much to improve your results if you have someone doing your thinking and researching alongside you-someone who's interests are aligned with yours. And that's why we have Kris on the case!

Dan Denning
for The Daily Reckoning Australia

• Equity Premium Will Be Replaced With a Tangible Asset Premium
• More Money in Cash Right Now Than Equity in U.S. Companies
• Stocks Better than Bonds When Inflation is a Big Threat
• The Price of Oil Explained by ‘Astrology’
• The Cash Flows Are Coming

First up is an issue that definitely affects the future of Aussie dividends: profits. You can't pay 'em out if you don't got 'em (unless you borrow 'em, which is just plain stupid). "Profit season looming as worst for 20 years," reports Lucy Battersby in today's Age. She says that analysts expect profits to be twenty percent lower than last year with "growth prospects" pretty dismal.

Maybe we're getting ahead of ourselves with the idea that Aussie companies will begin boosting dividends to attract shareholders. After all, Bloomberg reports that Aussie firms tapped the equity markets for over $90 billion in capital in the last fiscal year. It's what you do when you're rebuilding your balance sheet and paring back debt.

In fact, RBA Governor Glenn Stevens-in addition to letting everyone one know the cash rate would remain at a 49-year low of three percent-encouraged corporate Australia to boost the stability of the financial system by bolstering balance sheets (more capital, less debt). Stevens said yesterday that, "While the considerable economic policy stimulus in train around the world should support recovery, it is likely to be slow at first. For it to be durable, continued progress in restoring balance sheets is essential."

What does that mean, though? Well in the long-run it's very good! In the short-run, it means slower growth and less business investment (capital spending). That probably means either increased unemployment, or much slower growth in employment, which puts pressure on wages (not that their moving up much anyway).

Here's a story commodity punters should keep an eye. The U.S. Commodities Futures Trading Commission is thinking about new regulations that limit positions sizes on commodities contracts. The agency says it wants to reduce "excessive speculation" in the commodity markets, especially the oil market. The agency will hold hearings in August.

Well, one way of looking at oil's rise to $147 is that it was all a beat up engineered by Goldman Sachs. That's what Matt Taibbi says in his latest Rolling Stone article, "The Great American Bubble Machine." It's a claim that the oil market is heavily manipulated by speculators and that the price of oil is divorced from the laws of supply and demand in the real economy.

Taibbi's piece is worth a read. But the CFTC is barking up the wrong tree if it wants to blame high energy prices entirely on speculators. One factor in oil's rise is clearly investment demand from traders and institutions that foresee the decline of the U.S. dollar. Another factor-subject to much debate-is Peak Oil itself (that global oil production is peaking). More on that tomorrow.

For now, we'd say this is another sign of increasing government control of the markets. Some people think this is good and long overdue. Some people don't. Either way, it looks like the world we're headed to. And it looks to us like a sure sign that the U.S. government wants to have a lot more control of what you do with your money (capital controls). We reckon the oil trading will just move to London.

More about dividends. Today's Financial Review reports that Aussie investors may miss out on $7 billion in dividends this year. The report cites research from Macquarie Securities which shows that Aussie companies paid out $48.6 billion in dividends last year but are on pace to pay out just $41.5 billion this year. Companies are preserving capital.

Again, we're not sure this is a bad thing. But it does mean that if you pursue a dividend strategy, you may have to look beyond traditional sources (banks) and do your homework. We've got Kris Sayce in the trenches doing just this work now and will report on it later this month. But what else might this renewed focus on dividends mean?

Well, it might mean the debauched age of capitalism-where companies borrowed money to speculate or invest in projects for which there was no sustainable demand-is well and truly over. It might mean companies will go back to returning earnings that are not reinvested to shareholders, where they belong.

Of course, for a company to return surplus earnings back to investors it must first have those earnings. And that is no mean feat in the post-industrial global economy. So rather than relying on the market itself to generate your dividend income for you, you'll probably have to work for it (find it).

And there is the risk that common stocks may simply be the wrong asset class to own for the next ten years. That is, there is the risk that even dividend stocks are still stocks. And if stocks are in secular bear market, it won't matter how much you get paid to own them. They will appreciate very slowly, and perhaps not at all versus inflation.

And now to debt. We've run across a few articles and charts on debt that were eye-opening. Speaking of which, please keep an eye out later today for a special invitation to an event we're putting on here in Melbourne. It will be a night dedicated to discussing this very subject.

And the main point? Not only are large (and growing) household and government debt levels making life tough for Aussies, they are part of a global power shift that threatens the economic security of industrial countries like Australia. Despite its tremendous resource wealth and proximity to developing giants India and China, Australia risks drowning itself in debt.

Or, as James G. Neuger writes for Bloomberg on the eve of the G-8 summit in Italy, "The run-up in debt has hastened a power shift that is sapping the industrial world's authority to impose its economic doctrine, currency arrangements, or greenhouse gas reduction strategies. Even some G-8 officials acknowledge that the group has lost its grip on the global recession they spawned."

"The industrial world is beset by the harshest economic conditions in a lifetime: a projected U.S. budget deficit of 13.6 percent of GDP in 2009, unmatched since World War II; an annualised 14.2 percent contraction in Japanese GDP in the first quarter, also the worst since the war; in the first three months of 2009, German exports had their steepest quarterly decline since 1970 when the date were first compiled."

But is debt really a problem here in Australia? The chart below from the Bank of International Settlements (BIS) shows that it is, and a big one at that. Australian households have the highest household debt to disposable income ratios in the world, according to the BIS. Most of household debt, of course, is mortgage debt. And households are happy to take on mortgage debt as long as house prices are rising, interest rates are low, and the job market is good.

But as you can see, in markets where interest rates have risen and house prices have fallen, households have already begun seriously deleveraging, repairing their balance sheets by saving more and spending less and relying on asset appreciating a lot less. This process-as much psychological as financial-has yet to happen in Australia. We believe it will (it's one of the things we're going to discuss at the Debt Summit.)

But debt is not just a household issue. It's a pension issue too. That's because Australia has a huge portion of its pension assets in stocks. And as the world economy deleverages, assets bought with borrowed money are sold or revalued. For Australians, that means a huge write down in the value of assets held by pension funds.

Check out the chart below from the International Monetary Fund (IMF). It shows that Australia's pension assets (mostly superannuation funds) are not only about 100% of GDP (or nearly $1 trillion), it shows that the bulk of those assets are not diversified at all. Most of it's in stocks. The rest is in property (a highly leveraged sector arguable even more vulnerable to deleveraging).

Click to enlarge

What does the chart really mean? It means that it's time for a serious rethink of how you manage your retirement assets. Super...stocks...porperty...how you make, keep, and grow your wealth is a serious challenge for the future. And the accumulation of vast household, corporate, and government debt is making it even more challenging.

In fact, government debt may be the other shoe to drop. We won't get into too much detail. But we'd suggest that Australia is treading down the path to where questions about the quality of its bonds-or worst case, its fiscal solvency itself-might start to be asked.

Granted, the public debt-to-GDP ratios in Australia are modest compared to the U.S. and the U.K. And even if they grow to around 16% of GDP (as the IMF suggests they will), they will still be much lower than other places around the world. But it's the casual attitude toward accruing these long-term liabilities that worries us. And it's also the affect rising public debt has on interest rates.

The IMF puts it this way: "Doubts about fiscal solvency-the risk that governments find it more convenient to repudiate their debt or to inflate it away-could lead to an increase in the cost of borrowing. In turn, higher interest rates (and exchange rate depreciations, particularly in countries with significant borrowing in foreign currency, like most emerging economies) could further add to government debts-in some cases, resulting in 'snowballing' debt dynamics. This scenario would be deleterious for global growth."

Yes, it would be bad for growth. And a 2003 study from the Federal Reserve (cited yesterday in the Times of London) says it would also be bad for interest rates. The study concludes that "a percentage point increase in the projected deficit-to-GDP ratio raises the 10-year bond rate expected to prevail five years into the future by 20 to 40 basis points; a typical estimate is about 25 basis points."

It was referring to increased borrowing costs for the U.S. government because of rising deficit-to-GDP ratios. But in the current Credit Depression, we have no reason to believe Aussie borrowing costs wouldn't rise too with rising deficit-to-GDP ratios.

"All else equal," study author Thomas Laubach concludes, "The results of this study suggest that interest rates rise by about 25 basis points in response to a percentage point increase in the projected de_cit-to-GDP ratio, and by about 4 basis points in response to a percentage point increase in the projected debt-to-GDP ratio."

And what does it mean? "The impact would be devastating by making it punitively expensive to finance national borrowings and leading to what Tim Congdon, founder of Lombard Street Research called a 'debt explosion.' Mr. Congdon said the study illustrated the 'horrifying' consequences for leading Western economies of bailing out their banks and attempting to stimulate markets by cutting taxes and boosting public spending. He said the markets had failed to digest fully the scale of fiscal largesse."

To be sure, if the cost of refinancing public debt doubles, it's going to be particularly nasty for the U.S. and the U.K., where public debt to GDP ratios are on the rise. But what would it mean for Australia, where public debt to GDP would be smaller, but a lot larger than it is today? Stay tuned...

Dan Denning
for The Daily Reckoning Australia

• Buying Stocks for Dividends Makes Sense…
• Corporate Debt is Just One Aspect of the National Debt Problem
• A Sea Change In Our Love of Debt
• Dividend Drop-Off: When Cushions Turn To Rocks
• Banks or BHP?

To some extent, things ARE getting better. For example, today is Friday. Yesterday was Thursday. Tomorrow is Saturday. Most people enjoy the weekend. We are that much closer to it now. Things ARE getting better.

Whether the real economy is any closer to working off the credit excesses of the last twenty years...well, that we doubt. But for every story on bad bets by banks and bad loans wandering around like zombies on the balance sheet, let’s not forget where all that money did not go: energy exploration and capacity expansion.

While the Western world was in a ten-year torrid love affair with residential real estate and mortgage securitisation (with a fling in credit default insurance trading on the side) it forgot to keep looking for oil and gas in sufficient quantity to meet growing demand from the developing world. It was a structural mistake, and, it turns out, an intriguing investment/speculative bonanza.

For example, earlier this week Malaysia oil giant Petronas signed a deal to take two million tonnes a year of LNG for the next twenty years from the LNG project in Queensland run by Santos. The deal begins in 2014. BG signed a similar deal last month to supply LNG to China National Offshore Oil Company.

What’s remarkable about so many foreign companies and big money getting into Queensland LNG plays is that no one has a commercial process yet to turn coal-seam-gas (CSG) into LNG. This is why we consider the CSG LNG plays to be unconventional energy plays and thus more speculative than the off-shore deepwater LNG production from companies like Woodside Petroleum (a Diggers and Drillers stalwart).

But the speculative nature of the smaller Aussie-listed players in the CSG and LNG industries is what makes them the perfect province for small-caps editor Kris Sayce. He’s been all over the story (having just taken profits of over 450% on one share). And just today Kris published his latest issue of the Australian Small Cap Investigator. It’s another exciting unconventional energy play. If you aren’t an ASI reader yet, you can become one by going here.

The LNG market is derivative of the oil price, by the way, but not in the toxic, weapons-of-mass-financial-destruction way. That is, LNG prices will probably track oil prices higher, as long as oil prices continue to rise (which we think they obviously will over time). Your main risk in these stocks (not excluding production failures, bad management, or funding bottlenecks) is that the oil price crashes again. But with markets tip-toeing the recovery line, oil seems to be firming up around US$70.

Bonds, however, are looking rather infirm. Prices fell and yields rose on U.S. Treasury bonds. This is easy enough to dismiss as a natural consequence of the recovery theme gaining traction. But might also have something to do with the fact that the U.S. Treasury will auction another $140 billion in bonds next week.

That amount tops the $104 billion amount auctioned last week. It’s a lot of borrowing, isn’t it? The auction on June 25th will include $40 billion in two-year notes, $37 billion in five-year notes, and $27 billion in seven-year notes. The U.S. government ran a $189 billion deficit...in the month of May.

Note the absence of 30-year bonds in this auction. Whether by design or by accident, this confirms that U.S. borrowing is become a lot more interest rate sensitive. Creditors, we think, are beginning to shy away from lending to the U.S. at fixed rates for longer than ten years. They want their money back before the value of their investments is inflated away by quantitative easing. This makes funding U.S. debt more expensive...and vulnerable to a spike in yields.

Speaking of counterfeiting, did you see the story of two “alleged Japanese businessmen” who were arrested with $134 billion in allegedly fake U.S. Treasury bonds while trying to cross the border from Italy to Switzerland? The story sent the Internet into a tizzy, speculating if Japan—which had expressed “unshakeable confidence” in the U.S. dollar earlier in the week—was secretly unloading a huge chunk of its U.S. debt. The U.S. Treasury Department has since said that the bonds were fake and that no one, repeat no one, was attempting to quietly dump U.S. bonds.

Ahem. Nothing to see here. Move along.

And finally, a quick follow up to our report yesterday about problems in Aussie bank land. The Reserve Bank of Australia published a report yesterday providing an interesting insight into how Australia’s banks fund their lending. If you are into these sorts of things, you can find the report here.

If you are not into these sorts of things, we will give you the brief version of what we think the report suggests about the future of Australia’s capital markets: the RBA has lost control of the price of money in Australia.

The main driver in the cost of capital for Australia’s banks is not the RBA’s cash rate but the global cost of capital. In other words, the credit depression is already leading to higher capital costs in Australia beyond the control of the government and the RBA. This could lead to lower bank lending down the track and less growth (lower business investment, fewer funds available for commercial property development and residential real estate). It could also lead to more government lending and money printing to fill the lending gap, which would lead to higher interest rates and an Aussie gold price.

We maintained earlier in the week that the property boom in Australia was paid for with money borrowed from foreigners. The RBA’s numbers show that the big four banks source 45% of their funding from domestic depositors. The rest of the bank funding comes from a combination of foreign borrowing, short-term bonds in the domestic capital market, long-term bonds in the domestic capital market, and securitisation of things like residential mortgages.

We’re not sure how this percentage break down compares to other countries’ bank funding. But you can still draw a few conclusions from the RBA study. First, Australian banks are putting up interest rates in part to attract more depositors because deposits are becoming a more important source of funding. This reflects the growing importance of deposits as a source of funding versus, say, securitisation, which has all but dried up with the credit crunch..

While politicians may whinge about the banks putting up rates, you can also argue that Aussie banks have to put up rates on savings and other accounts in order to attract more money used for domestic lending. If rates don’t go up, neither will lending. And without a lending recovery, you can’t have an economic recovery. Of course higher rates might attract savers and increase the supply of loanable funds, but they are generally matched with higher borrowing costs too.

If it sounds like a bit of a paradox, it is. But it also illustrates some of the internal contractions that result from having an economy addicted to credit. If we can get in touch with him, we’ll ask Shawn Cownah to comment next week.

In the meantime, Aussie banks are paying more to borrow in international capital markets. It also costs them more to hedge their currency risk. Both factors squeeze the banks. And the banks like to pass the squeeze on to customers.

We’ll have more on the subject next week. But for now, we think this shows that the contrary to received wisdom that Australia’s banks are immune and insulated from the GFC, the effects are already being felt. And in a credit depression, we suspect the effects will begin to multiply this year and next. Until next week...

Dan Denning
for The Daily Reckoning Australia

• Aussie Banks Addicted to Foreign Borrowing
• Were the Government’s Stress Tests a Bogus Exercise in Deception?
• A National Mortgage Bubble
• Australia to Borrow as Much as $300 billion
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit