"The damage caused by high taxation during the Great Depression is the real lesson we should learn. A government simply cannot tax a country into prosperity. If there were one warning I'd give to all who will listen, it is that U.S. federal and state tax policies are on an economic crash trajectory today just as they were in the 1930s.

"The Smoot-Hawley tariff of June 1930 was the catalyst that got the whole process going. It was the largest single increase in taxes on trade during peacetime and precipitated massive retaliation by foreign governments on U.S. products...beginning in 1932 the lowest personal income tax rate was raised to 4% from less than one-half of 1% while the highest rate was raised to 63% from 25%. (That's not a misprint!)... By the end of January 1934 the price of gold, most of which had been confiscated by the government, was raised to $35 per ounce. In other words, in less than one year the government confiscated as much gold as it could at $20.67 an ounce and then devalued the dollar in terms of gold by almost 60%. That's one helluva tax....

"Inflation can and did occur during a depression, and that inflation was strictly a monetary phenomenon..."

"The 1933-34 devaluation of the dollar caused the money supply to grow by over 60% from April 1933 to March 1937, and over that same period the monetary base grew by over 35% and adjusted reserves grew by about 100%. Monetary policy was about as easy as it could get. The consumer price index from early 1933 through mid-1937 rose by about 15% in spite of double-digit unemployment. And that's the story."

We had no doubt that inflation can occur during a depression; hey, we read the papers. Anyone who has followed the Zimbabwe story knows that you can have a deadly depression...and dizzying levels of inflation at the same time.

But there's always more to the story. Devaluing the dollar in terms of gold had the immediate effect of increasing the money supply - it was like adding zeros to the currency.

In our wallet is a ten trillion dollar Zimbabwean bill, with a picture of stones on it. Those words - 'ten trillion' - did not get printed on that bill by accident. We assume they got printed on their by a printer in the employ of a government that figured that the cost of printing a ten trillion dollar bill was less than the cost of not printing it.

That is, by a desperate government that had so fouled-up the economy that a period of hyperinflation might seem like an improvement. Besides, hyperinflation might have a therapeutic, purgative effect.

But let us not get sidetracked by hyperinflation. It is nowhere in sight. Nor is its more civilized cousin - normal, polite inflation. The money supply in America - as measured by M2 - is contracting. The banks get money from the feds, but they don't pass it along. The chain of reflation is broken - or at least temporarily stretched. Currently, it takes a long time for money to get from one end to the other. The cash tends to get waylaid -either by the bankers...or by consumers themselves. It stays in bank vaults...or in bank accounts. Money is not being multiplied by the speed by which it changes hands. Instead, it is divided by immobility. It sits. It shrinks. It waits for a real boom.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

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Granted, private investment-the kind that drives job growth-was down 20.4%. But it was down 50% in the previous reporting period. Less bad is net better, no?

Here in Australia the Reserve Bank publishes notes on monetary policy later this week. The Aussie dollar is pricing in rising Aussie interest rates. And though those rising rates might peeve new home buyers a bit, the conventional wisdom says rising rates aren't so bad, provided they are caused by renewed strength in the economy.

All this statistical hocus pocus belies the fact that there are still hundreds of billions (or trillions) in bad bank collateral still languishing on the balance sheets of banks. And in securitised form, this bad collateral putrefies in the accounts of pension funds, super annuation funds, local councils, and other institutions who are quietly hoping it improves.

And maybe it will! But we aren't counting on it. In fact we still reckon a second wave of losses is due to hit the global financial system for a lower equilibrium can be reached. First more asset deflation, then monetary policy-induced inflation.

It's one of the notes that came up several times in our highly-stimulating debt symposium Friday night here in Melbourne. There is a still a lot of debt deflating. This was the position argued persuasively by Dr. Steve Keen. Dr. Keen reckons the amount of bad debts in the system will weigh down asset prices, including stocks and residential property in Australia.

Right now, of course, there's a bit of reflation trade going on. Oil is up. Stocks are up. Property is up. And even U.S. bonds moved up on Friday. However this reflation is not yet a monster hyper-inflation - the kind we fear comes when excess bank reserves move off the Fed balance sheet and into the real economy.

The inflationary position-the one where the global expansion in the monetary base leads to out of control consumer price inflation in Western economies-was taking up by Money Morning editor Kris Sayce. We tend to agree with Kris' position. But the interesting mechanical challenge is how the expanded monetary base will translate into expanded money supply-something that hasn't happened yet because banks haven't resumed pre-crisis lending levels, leading many people to believe the crisis is over an inflation is not a threat.

By the way, the panel discussion lasted about an hour and twenty minutes. Obviously, it was a bit more detailed than we can get into here. But we hope to have a transcript ready later this week and will keep you posted. We thought it was a good discussion, although some readers had hoped there would be a clearer consensus on what exactly was happening and what exactly to do about it.

One panellist who was not concerned about the direction of interest rates or whether inflation or deflation was likely was Gabriel Andre. Perhaps our resident Frenchman was content with the 45% gain he'd just advised readers to take trading a base metals stock that has rallied over the last month.

But his point, to be fair, was that this is not a market for a fundamentalist position. Trader's neutrality that observes only volume and price directions might be the most telling data. "The direction of currencies must always be looked at in pairs. Right now, the interest rate is the big driver for the Aussie dollar, not the growing deficits. But either way, it is a tradeable event. A weaker U.S. dollar is bullish for the commodities. However when the dollar rallies, the commodities complex weakens. Equity traders can take advantage of this, but with risks of course."

One item on which there was consensus? Aussie house prices. Australia will not be the only housing market in the world to escape a significant correction, the panel concluded. When the fall will take place and how big it will be depend on other factors (interest rates, bank lending, government support).

That said, a contrarian might view the bearish consensus on the direction of house prices as a bullish signal. We'll see. For now, the market is in definite bullish mood, until earnings or economic news contradict it. More on both tomorrow.

Dan Denning
for The Daily Reckoning Australia

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My outlook for this period is very bullish. Having spent both the peace and productivity dividends of the last few decades, the current direction of government policy - increasingly interventionist - threatens to set in motion the forces of capital flight... into gold. The effect of this on the dollar will be historic. There is no more honest a measurement for this forecast.

However, it is a three-five year outlook. It may start to unwind tomorrow, or perhaps not for two or three years.

Technically, the long-term chart contains no great knowledge. I don't put much stock in the charts of any price trend spanning more than 10 years. My calls would lag major turning points by about five years. But as far as the long-term chart goes, the gold price is still in a long-term bull market.

The last highest low in the eight-year bull trend lies at around $540, which is just above the final resistance point of the previous bear - the break out point after which the gold price accelerated in 2005...the year that Bernanke was chosen to head up the Fed. Go figure - turns out gold was right about him.

However, the more normal "primary" trend support lies at around $700.

The "primary" trend is the sequence that shows up most prominently in the five-10 year (weekly or monthly) chart.

In the case of gold, it is the trend that began back seven or eight years ago.

In a normal trend, the correction lows stop at previous highs, or resistance levels, which are at the $700 mark here. Note that the bulls bumped up against that level a few times during 2006 and 2007, before ultimately breaking out. That just makes support that much more significant at this level.

However, during a correction to the primary sequence, the normal support points might fail, and it becomes difficult to figure out whether it is still a bull market at all. In other words, it is possible to see gold prices fall to $600, or even $540, even if the general bull market is still on.

Percentagewise, a correction of just such magnitude occurred in 1975. Gold prices fell from around $200 per ounce at the 1974 peak to just above $100 a year later, before soaring to new highs, and to over $600 by 1980. So the long-term technicals tell us almost nothing, except that there is room on the downside whether or not the bull market is still on.

There are two facts, however, that argue against a correction of the same magnitude today.

One is technical, sort of, and the other is fundamental.

From a technical standpoint, it should be noted that the advance in gold prices leading up to 1975 was larger (percentagewise) than the advance from the $260 low in 2001, and occurred over a shorter time frame. I don't know how much that may be worth, but it's something to consider.

Fundamentally speaking, moreover, simply comparing the Federal Reserve's policies today with those of 1973-74, when it was similarly trying to rescue the world economy from a crisis that saw a 40% decline in the Dow, it cannot be denied that the current policy is far more inflationary... more bold... more off the charts, if you will. If the Fed underestimated its contribution to the inflationary events of the '70s, as Bernanke argued in a speech about inflation last year, what is the 2008 Fed doing?

The Medium-term Outlook, One-Two Years

My outlook for this period is also quite bullish for gold, as the positive short-term effects of the government's current policies begin to wear off and the negative effects start to set in sometime in this time frame. I know this is counterintuitive to anyone who believes what the government is doing today is beneficial, but that is really the only way it can work. In this period, you will see asset prices recover, along with commodity prices, and maybe even a fleeting boom (bubble) somewhere, like in biotech, or public works - wherever. However, the rising tide won't come in fast or high enough to keep all the boats rising like in other bull markets, or even in significant bear market advances.

Let me distinguish here between a recovery in the economy and reflation.

I expect significant deterioration in the economic fundamentals in the medium term. However, much of it is priced in, and the effects of monetary debasement will underpin the dollar value of the soundest assets. Indeed, only the soundest equity or real estate assets will provide real protection against the confiscatory policies of governments over this period. These include gold-related assets, and some of the other important commodities, though it isn't certain whether gold will outperform in this time frame.

It could take a full year for inflation expectations to recover from their current trough.

Moreover, although the Fed has been a leader in the reinflation program in 2008, it had not inflated nearly as much as the other central banks between 2003-2007. This fact created the illusion of a global boom that would sustain even as the U.S. economy recessed. Now it is being liquidated.

That is one of the reasons the commodity liquidation was so excessive, and also why the dollar rallied this summer. I don't know exactly what to expect from the dollar in the next year or two, but at best, trade should continue to be choppy.

Currency markets won't offer much opportunity for most people until the dollar's bear market resumes - sometime after 2009, in my judgment. However, this should not hinder gold's performance. Moreover, my feeling is that the Fed will pursue a low interest rate policy for longer than other central banks, which will eventually be the catalyst that undermines the dollar and sets it up for the final chapter in its bear market - the one that leads to a brush with hyperinflation.

Technically, the intermediate trend (i.e., the nine-month trend) is still down. The bulls have bounced off normal primary support at $700 nicely, and October tends to herald correction lows, seasonally speaking. Most of my leading indicators, including gold shares, moreover, suggest the low is in.

The technical objective of the seven-month top formed January-July 2008 was also already achieved at $695, plus or minus, suggesting the bear leg is complete. However, until the last lowest high ($940) in the downtrend is cleared, we have to tame our enthusiasm. What's more, the current rally has stalled at the downtrend line, which intersects the current time horizon at about $890.

If the bulls can't make it back up to at least the $940 high of September/October before the market falls back through $830, then I would worry the market MIGHT either retest its $690 low, or go lower.

The Short-term Outlook, One-Three Months

My outlook for this period is neutral to bullish, with the possibility of one more test of support in the mid-high $700s if bullish sentiment returns to Wall Street prematurely. Although the policies governments are pursuing are fundamentally and relatively bullish for gold, it is more than possible that they engender a recovery confidence in the short term that may hinder the performance of gold.

Technically, the objective of the October-November ascending triangle (bottom) in the chart below has completed at $875-880.

The last highest low in the short-term sequence is around $830. If the market falls through this level before extending the current rally to the $940 area, as mentioned above, there is the slight risk that there is something wrong with my bullish medium-term (or intermediate) outlook above.

But this risk is not that great considering all the bullish permutations that could still take shape on the chart. Still, the most likely scenario in my mind is for a pullback to somewhere between $750-800, whether or not the current two-month sequence extends to $940 in the next few weeks.

If the pullback starts now before a higher high, I'd put it at the low end of the shaded area in the chart ($740); if it starts higher, say from $940, it could stop a little higher, like $775-800.

But until we get over $900, the $830 handle should be watched, as a break through it before a higher high could trigger the liquidation of the two-month advance and start a correction to at least $775.

Ed Bugos
for The Daily Reckoning Australia

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