The 4-lane Sheik Zayed road stretching between Dubai and Abu Dhabi is, at best, a competition for speed; at worst it's a death trap. Among the UAE's claim to world's largest shopping mall, world's tallest building and world's longest metro built in "one go", is this highways claim: to one of the world's biggest automobile pile-ups.

On March 12, 2008, 25 cars traveling along the route burst into flames after piling into one another as a band of fog rolled in from the Gulf. Nearly 60 cars were in the accident altogether... 347 people were injured in the crash, 6 lost their lives.

"The crash happened because everyone was speeding despite the severe weather conditions," an Abu Dhabi traffic police officer said at the crash site, as reported by the Gulf News. "Drivers weren't leaving a safe distance between cars and this resulted in everyone hitting each other after the first crash."

A documentary short posted on YouTube capturing the 911 calls placed from motorists describes 'Foggy Tuesday' as a morning devoid of "human caution." The film also heralds the obvious bravery of the men who arrived from the Abu Dhabi fire, police and rescue crews to save those who'd become entangled in the brouhaha.

We will not hold you in suspense any longer...the metaphor suggested by this fantastic auto accident is a perfect fit for those studying the Dubai property bust. And like the writer of a Hollywood script, we cannot help by bring it to your attention.

Yesterday, on the recommendation of our new friend Moe, we traveled the same stretch of Sheik Zayed highway where the accident had taken place. Mohammad "Moe" Fathi Al Abrozani a Bahrainian-Qtari whose mother was an Iranian-American. Moe was born in Abu Dhabi, educated in California, lived briefly in New York and Chicago, then spent seven years in Germany. (His German is so fluent our German friends, Andre and Vereena, here in Dubai did not expect him to be Arabic when they first met him in person.)

Moe had returned to the Middle East to take part in the expansive boom attracting so much attention around the globe. He's now an executive with TwoFour54 Media, a firm set up by the government in Abu Dhabi to woo Western firms into establishing their Middle East operations in the new Media City in the UAE's capitol city. The rulers of Abu Dhabi had witnessed the efforts, successes and failures of their fellow emirate, Dubai, and have since vowed to create a modern media communications hub greater than anything now in existence.

"Why mess with visas, permits and expatriate contracts down in Dubai?" Moe asked us at dinner the other night, "when you can come to Abu Dhabi and get them all from the government free...?" One foggy morning in the year 2008, the reckless speculation that spurned much of the outrageous development projects in Dubai began to pile up on each other. Now the motionless construction sites lay in wait for assistance. In a scene familiar across the West, Abu Dhabi, the company line suggests, has "come to the rescue" of Dubai; with low cost loans; paper money and the sincerity of an assassin.

When we met up with Moe and Andre at Shakespeare's a brand-new bar in the all-new Souk Al Bahar, they were quietly puffing from sisha - the traditional water pipes bubbling with aromatic smoke. Our mission in the region was and is simple. We want to establish a presence on the ground from which we can monitor the developments and assess investment opportunities in Dubai, the UAE and across the Middle East unfiltered by the mainstream press. But here we were being asked to consider moving the infrastructure of our publishing business, our families, our lives, half way around the world to the desert. Bloomberg, CNN, Forbes are all moving and or expanding their operations in either Dubai or Abu Dhabi.

Why shouldn't we? Our friends in Abu Dhabi are apparently ready and willing to help.

Dubai and Abu Dhabi, the two leading Emirates of the UAE are relatively new to the global finance and trade... but they want you to know they have arrived in high style. This weekend, Formula One racing makes its debut in Abu Dhabi. The government had to pull workers from several of its five star seaside resort project to complete the track and facilities on time. Ferrari World, a massive theme park dedicated to the sport sits nearby. Yesterday, the Emirates Palace Hotel - the world's first seven-star hotel - Demi Moore, Hilary Swank, and last year's Oscar winner, Freida Pinto (Slumdog Millionaire) graced the opening ceremonies of the Middle East Film Festival. The Abu Dhabi sovereign wealth fund has famously leveraged their way into both of the leading football franchises in the world - FC Barcelona and Manchester United.

Still, our friend Peter Cooper recalls a time in his own family history when Dubai was nothing but a backwater of the British Empire, a port full of smugglers, nomads and thieves. His great uncle had been stationed here during World War II. At the time, the strife caused by the war left the ragtag bunch group of 7,000 residents on the edge of starvation.

Sheik Rashid, the father of modern Dubai, dredged the Creek in the 1950s establishing Dubai as a free trade port. At the time, too, the Creek dredging project was roundly criticized, as it should have been. The project cost nearly 3 times Dubai's annual GDP. But it also established Dubai as the trading center for goods coming into the Middle East. If you go down by the creek today there are Iranian Dhows - the Middle East's answer to the Chinese Junk - bringing rice, rugs and refrigerators back and forth across the Persian Gulf. Iran's ports are about a two-day drift away for these wooden ships. Kuwait and Iraq a day or two more. Bahrain, Qtar, Oman closer still. Without the fantastic success of that initial dredging project, we wouldn't be writing to you from the desert today.

"Dubai the hot spot..." has been a center of trade, smuggling and the rougher trades ever since. As the back jacket copy on a 1970s novel about gold smugglers in Dubai written by the French Connection author Robin Moore indicates: "Dubai, where adventurers play the world's most dangerous games...gold, sex, oil and war. Cold- blooded adventurers in a blistering Mideast empire where life is cheap and no price too high for pleasure." The novel is still banned here because the sheiks don't like the image it portrays.

The promise of riches, however, is part of the region's allure and what has attracted those expatriates who chosen to ride out the bust and continue to live here to this day.

The most recent gold rush, the boom in Dubai property, came on the heels of the terrorist attacks on September 11, 2001 and the same policy response that spawned a housing and consumption bubble across the United States, London and much of the West. Arabs flush with energy and trading capital brought much of that money home to the Middle East fearing a Western clamp down. At the same time, investors in dirham backed assets - the local currency which has enjoyed a US-dollar peg since November 1997 - benefited from the same era of low interest rates that soccer moms in Montgomery County, Maryland or gamblers in Las Vegas, Nevada did.

And like all booms, the property in Dubai witnessed its excess and its pathos. An article in this week's Asian edition of Time Magazine laments the manmade island project meant to mimic all the countries on the planet. "The World is one of many architectural fantasies in Dubai that now appear to be shimmering mirages. The emirate boasts the 818m Burj Dubai, the world's tallest skyscraper; a manmade island shaped like a giant palm; a ski slope in a shopping mall; an 18-hole golf course in the middle of the desert that will slurp down 3.8 million liters of water a day. But the dozens of giant cranes that once littered the skyline are beginning to migrate elsewhere. Dubai today has the feel of a futuristic, five star ghost town blasted by sandstorms."

"The fools!" we can hear readers of Time Asia chuckle with superiority. Everyone likes to kick a gambler when he's down.

But the story remains. On our way to Abu Dhabi yesterday we passed by the free zone surrounding the new deepwater global trading port at Jebel Ali. Business Bay near Jebel Ali is the home to many of the Bubble Era development projects, 30-story towers standing side-by-side, dark windowed and tenantless.

We suspect many of these nutty projects - like the City of Arabia, which had boasted an amusement park full of life size animatronic dinosaurs as its calling card during the boom - will never find the funding to finish. More sober projects that are or are nearing completion will likely take years to find tenants. And those "investors" who bet big and large on Dubai property in 2003-08 are no doubt already wishing they never had.

But the free zone near Jebel Ali also the site of Dubai's real potential; banking and trade. Corporate tax rates in are effectively zero. You name a multinational and Moe can point to their local subsidiary. The Dubai Mall, for example, is reported to need 10,000 shoppers a day to break even but now only sports around 7,000. Why do the world's most famous brand names all have shops open and spiffy already, we couldn't help but wonder. It has to be for those fine tax rates, we couldn't help but conclude.

Among other racy themes we heard this week, Dubai is supposed to now be the world capitol of the flesh trade. And the gold price hit an all- time high early in the week after we arrived sparked by rumors the GCC would back a unified currency with gold and provide oil traders an alternative pricing unit than the US dollar...

We suspect this fantastic wreck in the desert is only one scene in a long, exhilarating drama. We're not "long" Dubai in any real investment sense. Not now anyway. But, like most onlookers to the spectacle, we struggle to avert our eyes. The story promises more exciting car chases, more steamy sex scenes and political intrigue to come...and we'd be lying if we didn't admit we're suckers for a good story. And, who knows, we may open an office of our own there.

Regards,

Addison Wiggin
for The Daily Reckoning Australia

• Qatar Relies on Natural Gas Reserves While Dubai Leans on Trade and Finance
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Interesting huh? Consumer credit has fallen off a cliff.

What does that mean exactly? It means Americans aren't borrowing...and they aren't buying either.

This weekend, The New York Times noticed:

"Americans stop buying; trade deficit declines" begins the headline.

This is the story we've been telling here at The Daily Reckoning for two years. Americans have to cut back. They are out of time and out of money. Ten years closer to retirement than they were in before the tech stock crash, Baby Boomers are not a penny richer. Now, they're facing a funky economy where housing prices are in decline, jobs are hard to find and lenders are reticent to lend them more money. Daddy has finally taken the T-bird away.

But wait...if the Baby Boomers stop spending won't it have, like, repercussions?

The NYT continues:

"For the first eight months of the year, the United States trade deficit with China is down by about 14 percent or $20 billion, compared with one year ago. The nation's trade deficit with Japan has shrunk by almost 20 percent, and its deficits with Mexico, Canada and the European Union are down more than 40 percent.

"The huge shift stems mainly from the staggering collapse in trade. With credit markets frozen and Americans facing the highest unemployment in more than 30 years, the United States suddenly stopped shopping overseas at anywhere near the volumes that had become normal."

Americans were the world's champion consumers. Just lend them money; they'd spend it. But when they stop spending it brings a hush to the entire planet. The malls go quiet...trucks slow down...ships are idled...and finally factories are shut down. Clerks, drivers, stevedores and assembly line workers all go home. That is what a depression is all about.

The feds are trying to get consumers to spend again. They've given them tax rebates, incentives, loans, and bribes. They've run a federal deficit three times higher than the previous record. They promise $1 trillion deficits "as far as the eye can see." And they put at risk a sum of money equal almost to the entire US GDP.

Still those hardheaded consumers won't consume like they're supposed to.

Suddenly, it's the 'Age of Thrift.'

But if it's really the age of thrift, the stock market doesn't seem to have gotten the message. The Dow rose 78 points on Friday, to a new post-crash high. Oil held at over $72. And gold lost $7 to close at $1,049.

What are stock market investors thinking? Are they thinking at all?

If the consumer credit party is over...and the Baby Boomers are on the wagon...is it really possible for US businesses to grow...and prosper?

Yes, it is. America has great businesses with great brands. As the dollar falls it should be able for them to gain global market share in some sectors. But 70% of the economy is consumer spending. Until that changes, the US economy is hostage to US consumer spending. When consumers stop consuming, the US economy's wheels stop turning.

Okay, so you're thinking: "Well...maybe Americans have to cut back, but there are plenty of other people in the world. Let them do the buying for a while!"

And you are right. America has less than 5% of the world's population. But it consumes more than 20% of the total world's output - as measured by GDP. Clearly, Americans have been doing more than their fair share. It's time to let the foreigners belly up to the bar. Heck, they're skinny. They could use a good drink.

In time, foreigners will spend more. We don't doubt it. But rebalancing the world's economies won't happen overnight. Nor even in a couple years. It will take a long, long time. And a lot of investment in new tools, new training, and new techniques. Until that happens, when US consumers stop buying it slows wheels all over the world.

Every time finance ministers and heads of state get together they talk about "rebalancing" the world economy. They promise to take steps to make it happen. But so far, the market is doing all the rebalancing work on its own.

And instead of letting nature take her course...allowing the invisible hand of capitalism to direct capital to where it is actually needed...the heavy hand of government blocks the process of correction.

Credit is still contracting. And Reuters reports that "small US firms face credit squeeze."

In theory, a genuine recovery in the United States could be led by exports. A cheaper dollar...and a cheaper workforce (in global terms)...would make the United States a better competitor.

But even a cheaper dollar is not guaranteed. Consumers may have stopped borrowing, but the US government borrows more than ever. This borrowing - in dollars - increases demand for greenbacks and may actually sustain the dollar at a higher level than it should be. The feds' appetite for borrowing could also force up interest rates - further restricting small businesses' access to easy credit.

There is a big difference between selling a few more Harley Davidsons overseas and real export-led economic growth for the US economy. The latter would require hundreds...thousands...of Harley Davidson enterprises, selling billions worth of goods and services to foreigners. And right now, those enterprises don't exist. They have no lobbyists trying to get TARP funds. They have no pet Congressmen slipping tax breaks for them into defense bills. They have no unions backing them. How could they; they haven't even gotten off the ground yet. And they may never get off the ground if they can't get financing.

The boomers are saving. They put their money into the safest possible place - US bonds! That is, they lend it to the government. They're the feds' biggest single source of financing - even bigger than the Chinese.

Meanwhile, the feds pump billions into the banking system. They supply the banks with capital for expansion and consumption. But instead of making loans to the private sector, the banks take the feds' money and lend it right back to them. They can borrow at a negligible rate...and then use the money to buy long-dated T-bonds yielding over 4%. Result: banks make money; the private sector has no money to create new businesses.

This weekend, we had a conversation with an English carpenter.

"It's rough. I remember just a couple of years ago, I could get work anywhere. Now it's off and on. I still find work, but I have a lot of free time too.

"It's not easy. Not with four children. We don't have any choice. We don't get any public benefits, you know...because I'm working. But I'm not working as much as I used to. And I'm not getting paid as much. So what can we do? We have to tighten our belts. We get by. But we're definitely not spending money they way we used to. In fact, I wish we hadn't spent so much back then. I'd like to have some of that money now."

A report in the Telegraph predicts British property prices - which have been in an upward trend for several months - are headed down again...with a 17% decline expected.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Is Gold at $1000 a Bargain…Or a Trap?
• Until This Debt is Reduced, Americans Will Be Reluctant to Borrow or Spend
• Baby Boomers Face Early Retirement With No Money Saved
• Americans Have No Money to Spend Because They Already Spent It!
• The Country is Going into a Recession with its Finances in the Worst Shape Ever

Qatar's greatest asset is its natural gas reserves. In fact, the largest gas field in the world is here. Its discoverers were disappointed when they found it in 1971. They were looking for oil.

The boom Qatar now enjoys is the result of some daring investments in liquefied natural gas (LNG) back when people thought doing such a thing was a little batty. Faisal Al Suwaidi, the head of Qatargas, deserves the props for his wager, which have paid off handsomely. Today, Qatar produces about one-quarter of the world's natural gas.

Qatar supplies such faraway customers as Japan, India and China. Qatargas also operates the largest LNG terminal in Europe at South Hook on the Welsh coast. This facility provides Britain with a fifth of its gas needs.

Qatar's dominant position has filled its coffers and changed the country forever. On a per capital basis, it is one of the wealthiest countries in the world. And given the world's growing energy demands and the appeal of clean-burning (and cheaper) natural gas when compared with oil, Qatar seems in a good position.

In Dubai, the story is quite different, as Dubai does not have Qatar's gas reserves, nor does it have much oil. Dubai's story is one of trade and finance.

As I write, the sun is just peeking over the horizon. It is dawn in Dubai. Out my hotel window, I can see two buildings with cranes over them and in the distance another building in scaffolding. For a city that was once booming and turned bust - as with most places - there is still a lot of construction going on.

As recently as September 2008, realtors could claim that no one had lost money in the Dubai property market. That's no longer true. In fact, now the market has too much of just about every property type. One headline story noted how 32,000 homes are about to come on the market next year, which is a big number to choke down in any city. Dubai had a huge property boom and now must suffer the flip side.

The hotels, too, are pretty empty. We are staying at the new Address Hotel downtown, which has been open for only 25 days, we are told. I'm the first person to stay in my room. It still has that new carpet smell.

I wandered down for breakfast and was alone in a cavernous dining room. The hotel is brand-spanking new and everything looks wonderful. It's just mostly empty. I think there are more hotel workers than there are guests.

In Dubai, revenue per room is down 35% from a year ago. Yet there is still an expansion going on. Next year, estimates call for a 15% increase in the number of rooms. This would mean a 40% increase in two years.

Over breakfast, I perused my complimentary copy of The National. One of the things I like to do in a foreign city is to read the local newspapers. I'm kind of a newspaper junkie anyway - I get three dailies delivered to my doorstep at home. In any event, I always find interesting nuggets from a perspective you might not get if all you read is The Wall Street Journal or Financial Times.

Today's business page carried an array of tales... There was the arrival in Doha of a new LNG tanker, fresh from Seoul's shipbuilding docks. There was a story about how UAE consumer confidence is up. Also, notes on bond issues in the Gulf, the latest figures on money supply in Kuwait (it's rising at a frighteningly quick pace of 18.7%), the price of villas in Dubai and more. All sorts of little odds and ends that help paint the picture.

There was also a lot of chatter about infrastructure, which I found particularly interesting. Abu Dhabi, the capital of the UAE, which I will visit on this trip, is looking to raise $100 billion for infrastructure projects. From The National: "The emirate needs to fund new transport, electricity and telecommunications schemes..."

Dubai itself also has ambitious infrastructure spending plans. Last night, as we made our way to our hotel, we could see the new Dubai Metro stops along the way, which, lit up as they were in soft blue and white twinkling lights, looked like something out of the future.

Incredibly, the Dubai government last year spent about 45% of its budget on infrastructure projects - mostly on the roads and ports. But there is a lot more on tap, as The National reports:

"Dubai could invest as much as $20 billion in desalination projects in the next decade alone as it increases its water output by 2.72 billion liters a day... [There are also] plans to add 14,405 megawatts by 2017... Construction costs for those new plants amount to $11.6 billion, while infrastructure costs, including substations and transmission lines, will be about $11.6 billion."

This massive build-out is not unique to Dubai, or even the UAE. There are also big infrastructure projects of all kinds in India and China and other emerging markets.

Regards,

Chris Mayer
for The Daily Reckoning Australia

• Arab Wealth Pours Back into Dubai
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Two weeks ago, my business partner Chris Tate (www.tradinggame.com.au) and I caught up with Kris Sayce, your intrepid Money Morning editor and all-round gentleman. I'm still buzzing from the meeting. As we munched on our lunches, the three of us got into some really high level discussions about trading. We talked about what it means to achieve exceptional gains in the market, and why for some people, money just flows naturally into their trading accounts.

I really get a kick out of every time the three of us catch up, (and it's not just because I enjoy looking at my own reflection in their shiny bald-heads). It's because, when you meet with people like Kris, they tend to add clarity to your thinking that you just can't beat.

Kris asked me for my advice about how to help his readers achieve even more exceptionally cracking returns. So I've spent all morning huffing and puffing, and stomping around my office in deep thought. Yes, I've even been talking to myself and ranting a little, scaring the neighbours dogs... and then all of a sudden - Whammo! I came up with the solution. Before I tell you what I came up with, to make sure we're both on the same wavelength, take the time to...

• Imagine what it would feel like to not worry about money.
• Imagine unlocking the techniques used by the world's best professional traders, every day of their lives.
• Imagine knowing you've got a safety net so you never again feel fear while trading.

Well, if that's what you're aiming for, you'd better pay close attention to what I'm about to tell you.

The Solution

The simple truth is that without a clear idea regarding how to set a stop loss, you are sacrificing your future.

A stop loss tells you when to jump ship, and get out of your trade. I'm sure you know this - but have you really applied it? To join the elite inner circle of outrageously successful traders, your first aim must be capital preservation...

And this can only be achieved by setting a stop.

Yes, that's right. If you aim to rake in the dollars, and this is your number one priority, money will cheekily skip away from you and jump into someone else's pocket. Making money is a by-product of following your trading plan. Your plan must cover your entry rules, your exit rules and your position sizing methodology. Each of these three areas is essential to your success.

There are traders out there right now, making huge profits, while others around them are getting squashed. The difference between these two vastly different groups of people is the way they approach trading, and the methods that they use.

From the emails I'm getting over the past few weeks, many traders are struggling to find the best stop loss method to suit the current market conditions. Some haven't even realised the importance of setting a stop loss, until they got run over by the rampaging bears. So, let's start here and cover some of the basics.

Loss Control

Suppose you have $5000 to trade with, and you lose 50% of this amount. How much money in percentage terms do you have to make to breakeven on your next trade? If you automatically said 50%, this is incorrect. You need to make 100% on your remaining $2500, to make up the lost $2500, and break-even! Things are never as intuitive as they first appear. This table emphasizes the importance of keeping your losses small so that you can recover and continue to trade.

If you lose 25% of your account, you must make 33.3% profit on the remaining equity, simply to break-even. Keep your total equity drawdown to less than 20% and you have a chance of surviving in the sharemarket. Trading is not about avoiding risk - it is about managing risk.

Types of Stops

An initial stop is designed to protect your capital. Even successful traders find that they only make winning trades around 50% of the time. As long as the dollars gained outweigh the dollars lost, then you will be profitable, even if your hit-rate is quite low.

A breakeven stop will help lock in a no-loss trade. This type of stop is implemented once a trade has begun to co-operate and there is now little threat of your initial stop being hit. At least when you have moved your stop to breakeven, there is a chance that you will end up with a profitable trade. Especially with the application of leverage, it is important to move your stop to breakeven as soon as reasonably possible. This will minimise the potential drawdown of your account.

Trailing stops are designed to protect your profit. Once the trade has trended strongly in the expected direction, you can follow the trend by moving your stop. You could also decide to extract money from the position if the option hits your profit target. I only use profit targets for option and warrant trades, not for share trades. Profit targets tend to cap available profits. Learn to protect your profits as well as protecting your initial capital and you will be well on the way to trading effectively.

You may also need to consider a time stop if the instrument doesn't co-operate in your allotted time frame. Try not to be too trigger happy when exiting based on a time stop for a share. The markets distribute money from the impatient to the patient. Give your trade a chance to co-operate before exiting.

Be aware that if the market is dropping like a stone, it may gap past your stop loss level. If that happens to you, just exit anyway, even if your loss was greater than initially anticipated.

I've been exactly where you are now - filled with hope and determination, but unsure about the best way to become an exceptional trader. I can tell you one thing - until I committed to my own trading education, I was stuck. I just couldn't generate the trading results I felt I deserved. However, with the right techniques, you can break free.

I'm serious about helping you reach your own personal trading goals. If you genuinely want to become an ultra-versatile trader and develop an incredible lifestyle, you need a trading plan. If you're ready to put one together, just go to my website www.tradingsecrets.com.au, register your details, and as a gift, I'll email you my very own 'Trading Plan Template' straight away. It will help you work through all of the vital issues that need to be included in a sophisticated trading plan to give you an edge in the sharemarket.

In the next article, I'll be covering the specific methods that you can use to set a stop loss. So, stay tuned, because the best is yet to come.

Louise Bedford
for Money Morning Australia

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Reserve Bank economists now reckon that the recent coking and thermal coal deals inked between Aussie sellers and overseas buyers will haul in another $30 billion to the economy this year. That is not the kind of news the RBA wants to hear while it's busy putting out inflationary bush fires in the economy. But facts are facts.

Thirty billions dollars in coal and iron ore earnings, where will it go? To producers? To investors? To mining service companies like Walter Diversified Services (ASX:WDS)?

While you think on that, let's talk about "terms of trade" for a moment. "Terms of trade" is one of those terms of the trade that gets throw around by economists all the time. But what does it mean?

The simple definition is this: it's the ratio between export prices to import prices. If you get more for what you sell and pay less for what you buy, your terms of trade improve. And guess what people? Thanks to this particular moment in history, Australia gets a lot more for what it sells and pays a lot less for what it buys (except for crude oil).

The chart below is taken from a 2005 Reserve Bank research paper called "Long-Term Patterns in Australia's Terms of Trade," by Christian Gillitzer and Jonathan Kearns.

But we'll save you the trouble and tell you what it means in laymen's terms. The chart shows that the terms of trade exploded in the 1950s as Aussie exports of wheat and wool increased export earnings. Today's terms of trade ratio, by the way, is around 130, where those two dots on the right margin are. Will the index go to 1950s levels? And if it does, what will it mean for domestic spending in Australia?

In a speech given in February of last year, RBA assistant governor Malcolm Edey showed how an improvement in the terms of trade can lead to a rise in national income and, gulp, domestic demand. Think inflation.

"One of the consequences of the strong global economy, and particularly the growth of Chinese industrial demand," he said, "has been sustained upward pressure on a range of commodity prices. Over the past three years this has lifted Australia's terms of trade by around 30 per cent, the largest cumulative increase that we have experienced since the early 1970s."

"It is not hard to appreciate that this provides a significant boost to incomes and spending. With exports representing about a fifth of GDP, each 10 per cent increase in the terms of trade adds about 2 per cent to the value of national income," he concluded.

Whose income, though? This is the key question. Will the rise in export earnings lead to more spending (and if so, by who?). The answer will help determine if and how big future interest rate rises are.

According to today's Age, "While senior Reserve Bank and Treasury officials forecast last month that Australia was heading for a boost of 10% to 15% in the terms of trade in 2008-09, the Posco deal suggests the rise could be more like 20% to 25%. Next year could see the terms of trade - the ratio of export prices to import prices - overtake the record levels of the Korean War boom in 1951."

That's interesting. Yesterday we mentioned that the current rise in Chinese steel production (and growth in Aussie exports of iron ore and steel) happened during the great post-war expansion in Korea and Japan, when both countries effectively industrialised and built up their manufacturing bases.

Base metals demand grew in both countries, driving them south to Australia, where Lang Hancock was flying over the Pilbara in 1952, noting that all that red earth might just possibly be iron ore. The rest, as they say, is history. But as they also say, the past is prologue. China is coming south these days too, looking to build out its industrial and manufacturing base with Aussie coal, base metals, and minerals (heck, let's throw uranium and LNG in there too.)

Here are two scary charts for the RBA that suggest the terms of trade may improve even more in coming years, leading to more inflationary pressure in the economy via business spending.

First, when the terms of trade spiked in the 1950s, commodity prices were in a secular downtrend. What Australia was selling went up in price, while the general trend in prices for manufactured goods was down. Aussie ore went to Japan and Korea and came back, eventually as cheap manufactured goods.

Today, real commodity prices appear to have bottomed from a 200-year low around 2003. It was certainly a 20-year low. Whether the price of real commodities keeps going up, we'll have to see. But you have a situation where the price of manufactured goods continues to go lower (more global producers) at the same time the price of raw materials is going up.

As the chart above shows, Australian export prices are rising faster than commodity prices, while Australia's import prices are declining faster than world manufacturing prices.

Why that exactly would be the case is a bit of mystery. The paper's authors suggest that, "Australia's traditional mineral exports had been high value-to-bulk commodities such as copper, lead and zinc. Japan's prominence in Australia's commodity exports at the time is illustrated by the fact that by 1969/70 Japan imported 65 per cent of Australia's metal ores, coal, gas and petroleum exports."

The simpler explanation is that what Australia is exporting today-iron ore, coking coal, zinc, copper, and gold-is in greater demand than wool and what were 50 years ago, as reflected by higher prices. If anything, a recovery in the agricultural sector (rice and wheat especially) would deliver an even bigger boost to the terms of trade.

If China is the new Japan (and our theory of great post-war periods of industrialisation suggests that it is), then you see why the trend is sustainable and the terms of trade will grow even more. Export income should grow as export prices (and production volumes grow). They will only grow, of course, if business investment picks up. Business investment is the big driver of all wage and income growth, though. So if business investment grows, wages are going up.

Do you see why inflation is largely out of the Reserve Bank's hands now? It can control domestic consumption. But it cannot control foreign consumption of Australia's mineral exports. That's the demand driving business investment and Aussie wage growth.

On the import side, it's easy to see in a picture why Aussie import prices have been falling even faster than the average price of global manufactured goods: we're getting more stuff from Asia and less from Europe. Shipping costs are much lower. But prices are lower in the aggregate because low labour costs in Asia have led to a big decline in the price of manufactured goods globally. Wage and price disinflation from Asia, you could say.

So what does it all mean? It means export earnings will grow for commodity producers unless they run into the brick wall of rising energy costs, labour market constraints, or infrastructure bottlenecks, all three of which are possible.

There are other factors too. Rising global energy prices affect producers and prices. That could crimp global demand, Asian production, and thus Aussie resources. It's also possible that rising food and fuel prices trump falling prices for manufactured goods and lead to greater Aussie inflation. After all, food and fuel make up a greater portion of the household budget than DVDs and toasters.

Plus, 60% of Aussie GDP is consumer spending. If export earnings benefit mostly industrials and manufacturers, and they represent just 26% of all economic activity, then the effects of a huge boost in the terms of trade might be muted. Consumers will be hit hard by rising food and fuel prices while businesses, flush with export earnings, will hoard cash for the duration of the credit crunch.

And of course there's the possibility we could have big trouble in big China. We have speculated that China's long-term ambitions in Australia are…ambitious. But China itself a seething bundle of internal contradictions.

It is 1.2 billion people growing with great energy. But demographically, Chin is also getting old quickly and facing the health challenges that come from running an economy at breakneck speed without regard for workplace safety or the environment. It is a closed system trying to unleash the energy of economic growth but remain static politically.

Trying to move while standing still is neat trick. The only way we've ever seen it done is in a rocking chair, where you find motion and stasis at the same time. China's very attempt to industrialise right now may put the raw materials it needs to do so out of its strategic reach. This means price pressures on global energy and minerals.

It leads us to a world of energy haves and energy have-nots and of agricultural haves and have-nots. Where it takes us is anyone's guess. For Australia, for right now, it looks like it's taken us higher.

Dan Denning
The Daily Reckoning Australia

• Australian Trade Deficit Grows for 75th Consecutive Month
• The Future of the Australian Resource Market, Two Ways the Boom Could End
• Wage Pressure in China to Drive Up Cost of Goods in Australia
• Australia’s Current Account Deficit Up 4%
• China Performs a Kind of Financial Alchemy

Exports fell by 4%, or about $18.2 billion in the month. The big laggards were metal ores, minerals, and coal. Metal ores and mineral exports fell by 18% in the month, or $624 million. Coal exports fell by 16%, or $281 million. Coal and metal ores weren't exactly being lazy. You can blame the weather (flooding) and continued bottlenecks in export infrastructure.

There is a simple explanation for Australia's trade deficit: the country really doesn't make much. How else can you explain something that's been a regular feature of the economic landscape for the past 75 months? From our quick scan of the figures at the ABS, the last time the country ran a monthly trade surplus was in October of 2001.

Since then, of course, exports have ramped up with the resource boom. But as the Aussie dollar has strengthened and the U.S. dollar weakened, export profits have been tempered by the fact that Aussie exports face rising costs in local currency terms but get paid in weaker U.S. dollar prices.

The upside is that commodity prices have been rising. Some of this is dollar weakness. Some of it is too little supply. And much of it is growing demand. This all makes for rising prices.

And while we're on the subject of rising prices, let's hear it for iron ore, thermal coal, and coking coal!

The standoff with China over the iron ore contract is partially responsible for the $800 million fall off in trade revenue. But that revenue is about to soar again with a series of agreements on the price for steel making ingredients. How can the steel producers still make a profit with iron ore and coking coal prices rising so much? Hold that thought.

The Financial Review reported yesterday that BHP is close to sealing the deal with South Korean steel maker Posco for a coking coal price of US$300 in 2008-2009. That is up from US$97 last year. That's a nice little gain. Coking coal in the spot market is already going for around US$350, according to the Fin. Australia exports 68% of the world's seaborne coking coal.

Iron ore, you say? We covered it earlier this week. But we reckon the contract price will rise by at least 75% before June 30th. And even thermal coal for power plants is expected to at least double from its current contract price of US$56 per tonne.

Combined, the rise in coal prices should boost export income from by $35 billion to $56 billion. That will be handy to have. Still, don't expect a huge improvement in the trade deficit. If you look closely at the breakdown in the import figures, there's a lot Australians import from abroad.

The main three categories (according to the ABS) are consumption goods, capital goods, and intermediate goods. This includes things like textiles, electronics, toys, books, leisure items (in the consumption goods category) and things like civil aircraft parts, telecommunications equipment and industrial machinery (capital goods), as well as well as fuels, lubricants, papers, plastics and spare parts (intermediate goods).

If you don't make it here you have to buy it from somewhere, or have it not at all. Australia does produce some things. But for a rich Western economy, its production-and lets remember this a country of 20 million people-is largely concentrated in raw materials and agricultural goods, not finished manufactured products.

The strong dollar eases the pain of imports a bit, especially since many of the imports are cheap and come from Asia. But it's generally true that profit margins are greater in finished goods than raw materials. Australia's had its bacon saved in this respect because resource prices have been rising by so much and so quickly.

Makes you wonder what will happen in a generation or two (perhaps less), when the resource profit growth is gone and the country's productive capacity hasn't been diversified. Expect to see a lot of service jobs at low wages.

We were a bit gloomy yesterday about Australia's prospects for decreasing it reliance in imported refined fuels. A larger question might be whether the country can increase its net oil production. Consumption is growing faster than production. Like every major country in the world, Australia would like to find more domestic oil.

The good thing about finding oil is that geologists can tell you what kind of geologic formations bear oil. The bad thing about finding oil is that its getting more expensive, mostly because companies are having to look further and further off shore, just to find reserves to replace current production (not to ad to reserves.) The government is getting busy.

"The Australian government invited bids for 35 oil and gas exploration permits in five petroleum basins off the northwest and southwest coasts as it seeks to address a rising deficit in crude-oil supply," reports Angela Macdonald-Smith in Bloomberg. "Australian spending on exploration jumped 57 percent last year to a record $2.66 billion even as the number of wells drilled fell, as equipment and labor shortages drove up costs. Explorers need to boost work in frontier areas to avoid a A$28 billion petroleum trade deficit within a decade."

The permits on offer are for exploration in the Browse, Bonaparte, and Canarvon and Perth Basins. As you can see from the picture below, courtesy of the Department of Energy, Resources, and Tourism, all this years offshore exploration permits are in the West. Proceeding clockwise, the basins are Perth, Carnarvon, Roebuck, Browse, and Bonaparte.

Source: Department of Resources, Energy, and Tourism

There are a ton of off-shore petroleum development projects in WA from last year. We're also keeping our eye on off-shore natural gas in the Otway and Cooper Basins in South Australia.

Dan Denning
The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Terms of Trade Driving Runaway Australian Inflation
• The Future of the Australian Resource Market, Two Ways the Boom Could End
• BHP Billiton (ASX: BHP) to Report Second Half Results Today
• The Australian Resource Boom Isn’t Dead Yet