Outside Australia, all eyes are on Greece. According to Bloomberg, Germany and France want the Greek government to make concrete budget cuts before organising a bailout. Of course it's not just the Greeks that have a lot to lose if a deal isn't found. A lot of bondholders (banks) will lose too.

But the biggest loser of all is Europe's common currency itself. Monetary union in Europe was always an experiment. It got rid of all the old colourful paper currencies in Europe and replaced them with impressive looking new paper notes. It also made the euro a reserve currency to rival the dollar.

It now looks, though, like Europe's experiment with paper money may go up flames even faster than the U.S. dollar, which is an impressive achievement. Twelve economies, one interest rate policy, high government deficits as a matter of course....it's a mess. It makes high-yielding commodity currencies like the Aussie dollar and the Canadian loony look downright sexy.

One perverse irony of the Euros woes is that it might be good for the U.S. dollar. Still, the bond markets are telling us that the world is fed up (or over-fed) with U.S. debts. Dow Jones newswires reports that an auction of $25 billion in 10-year U.S. notes "did not go particularly well." It doesn't bode "particularly well" for an auction of $16 billion in thirty year bonds set for later this week.

Even though the 10-year auction was over-subscribed, this kind of action suggests higher yields (borrowing costs) ahead. That's an ominous sign if you have or plan to have large structural deficits. It's also a bad sign given that the Fed hasn't even begun its "exit strategy" from the bond markets. It's still supporting prices and suppressing yields.

If the mere indication that it's going to exit the market lessens demand for Treasuries, what will it's actual exit do? Come to think of it, what will happen when the Fed stops buying and the Chinese start selling? We reckon the Fed will have to a quick about face. More on that in second.

Further to yesterday's point about debt as a very bad habit, check out the chart below. It shows the large spike in gross and net interest paid to Australia's overseas creditors. By today's standards, paying out $30 billion in interest to your creditors (half of whom are in the U.S. and the U.K)seems like a fairly small price to pay for such an extravagant increase in house prices across the nation.

Just one small point, though. According the date, 37% of Australia's debt is denominated in Aussie dollars and 39% of it matures in 90 days or less. This makes the debt sensitive to exchange rates and extremely interest rate sensitive too. A spike in rates and/or a fall in the Aussie dollar makes paying back and servicing the debt much more expensive.

Perhaps this is one reason CBA is keeping more of its cash.

In any event, the net interest on the debt doesn't look back-breaking at these levels. But if the debt continues to accumulate or interest rates rise, it does start to get heavier. And at bottom is a simple financial point: interest paid on your borrowings doesn't increase your capital. It's just money sucked into a giant black hole.

You had better hope the capital goods or investments you made with your money compensate you for the cost of servicing your debts. In Australia's case, that means the country needs higher and higher house prices. By the way, the ABS reported yesterday that housing finance approvals fell by 5.5%. The question is begged: when housing finance slows down, will housing prices follow?

Yesterday we claimed that borrowing your way to national prosperity is a sure-fire way to servitude and political instability. Today, we aim to prove it. To do so, we cite this article from Reuters. It suggests that China is using or should use its large holdings of U.S. Treasury bonds as a cudgel with which to bludgeon the United States its strategic adversary/ indispensable economic partner.

Figures in the People's Liberation Army want the financiers to sell U.S. bonds as a way of punishing Washington for selling arms to Taiwan. Mind you this might not seem like such a good idea if the bond selling triggers a run on the dollar and swift devaluation in China's forex reserves. But maybe China's arsenal of U.S. bonds is a like a pile of bullets - they're no good unless you fire them.

Of course what we're suggesting is that China accumulated U.S. debt as both a by-product and a weapon. The huge stock of U.S. government securities was by product of China's trade strategy. That strategy was to keep its currency low and gain global manufacturing market share through low labour and production costs. The result was a blizzard of U.S. dollar trade surpluses that were reinvested into U.S. bonds.

You could say it's China that's paid for the wars in Afghanistan and Iraq.

But why is this bundle of bonds now a weapon? We think China's export-driven growth strategy is on its last legs. Labour unions in Europe and America given today's political climate and high unemployment - will have the ear of politicians. And they will be saying something like this, "Make the Chinese pay!"

What they'll mean is that China will be pressured to give up its main economic weapon - currency manipulation. This has kept Chinese exports cheap all over the world and led to the gutting of American manufacturing jobs. It's made it pretty tough on exporters in Europe too. As a result of China's dollar peg, European exporters suffered doubly from a weaker U.S. dollar. American goods were cheaper in Europe. But European goods were not cheaper in China.

So the unions and the politicians will probably not tolerate another leg of the global recession in which China gains more market share by keeping the currency peg and exporting its way to more growth (if growth is to be had). It brings us to the end-game of China's export-driven development.

It also brings us back to one of the great monetary questions of the day: when will China de-peg? The answer has always been simple: when it is in China's interests to do. To us, that means China will de-peg when the benefits of increased purchasing power in the currency are more important that dwindling export profits.

In other words, we think China is close to a new phase of growth that's driven by consumer demand, domestic consumption, and more mature Chinese capital markets open to foreign investment. A de-pegging of the currency would see a much stronger Yuan. This would give Chinese savers a lot of spending power on global markets. They would also be able to buy more Chinese goods, which might lead to higher wages in China too (and more stoking of consumer demand).

This is all a theory, of course. And we could be way wrong. But there will come a day when Chinese customers are worth more to Chinese producers than American customers. De-pegging the currency will bring that day forward. And it could be sooner than you think.

This means that the accumulation of forex reserves was never really meant to protect China from external trade shocks, although they would be handy in that event. It means they were a side effect of a trade strategy whose ultimate objective was to gain as much global manufacturing market share as possible.

Now, you might wonder why China would damage its own interests by "punishing" the United States and selling bonds. But it depends on what China's interests are. If China's interests are in fundamentally weakening an economic competitor and strategic adversary, then selling U.S. bonds is in China's interests.

China's ultimate interests are in regaining Taiwan. And we'd suggest it try and use its bond leverage to weaken U.S. resolve about defending Taiwan. And selling U.S. bonds or crashing the dollar wouldn't just weaken U.S. resolve. It would expose the loss of strategic influence that occurs when you are a chronic debtor nation.

Mind you the U.S. still has a lot of aircraft carriers, strategic bombers, and nuclear weapons. It's not like its bereft of tools of persuasion. But the basis of all those tools has always been a strong economy, a strong industrial base, and sound finances.

The question now is, if the base of military strength has been eroded, how long will the U.S. maintain its military advantage? Can America afford it? And when push comes to shove, will American voters demand that an American President defend Taiwan? Hmmn.

Dan Denning
for The Daily Reckoning Australia

• The Chinese and the Fed Both Buying U.S. Treasury Bonds
• David Murray Says You Become Dependent on Global Banks When Importing Capital
• China Continuing to Buy US Bonds “Every Day”
• China Performs a Kind of Financial Alchemy
• China Reduces Holdings of Treasury Securities

Only an economist would dare to look 10 years ahead. Only a fool would put money on it. Today, we do both. But our new "Trade of the Decade," is not so much a look into the future as it is a look at the past.

Ten years ago, your humble correspondent offered his first 'Trade of the Decade.' He should have stopped there, for the trade was a big success. It was a simpleton's trade: Sell US stocks/buy gold. That was in the year 2000. At that time, US stocks had been going up for the previous 18 years, multiplying investors' money 11 times. By then, stocks had been going up for so long that the memory of man ranneth not to the contrary. Investors' imaginations saw no alternative. Stocks for the Long Run was the title of a popular book. It was also an investment formula that seemed unbeatable.

Alas, the formula proved beatable. It was time for stocks to go the other way. The first decade of the 21st century proved to be the worst time to hold stocks since the '30s. Net returns were negative - especially when adjusted for inflation. Adjusted to the CPI, the Dow ended the decade down 40%.

The other side of the trade - the buy side - was just as simpleminded. Gold hit a high over $800 in 1980. Then, it slipped for the next 20 years. It didn't come to rest until September 1999 at $260. That was the famous "Brown Bottom" in the yellow metal...when the then chancellor of the exchequer, Gordon Brown, sold Britain's gold at the lowest price in two decades. (To bring readers up to date, now Mr. Brown applies his vision and energy to Britain's economic recovery efforts.)

Gold is real money. But in the years when gold was being beaten down, other forms of money were running wild. Financial assets mushroomed all over the globe. A whole new 'shadow banking' system emerged...with new financial instruments, representing trillions...no, hundreds of trillions...of dollars. Prices on everything were soaring - equity, debt, real property. It did not take a genius to see that gold would have to catch up, sooner or later. As it turned out, no major asset class did better. Gold finished every single year higher than the year before. It doubled. Then, it doubled again.

What made the trade a success was neither clairvoyance nor omniscience; it was merely an observation known as 'regression to the mean.' The word 'normal' has been in the dictionary for a long time. It must be there for a reason. What it describes is where things tend to go when they've gotten out of whack. Regression to the mean is so powerful, no one escapes it. For every decade of walking around time, a person spends a million years dead. Over a century, practically every human regresses to the grave. So, what is so abnormal now that regression to the mean is as certain as death?

Almost all investments are expensive by most historical measures. But if all go down, what will they go down against? Money! That's why real money - gold - is likely to go up again in the next 10 years. But gold is not cheap. It rose nearly 400% over the last 10 years and now is fairly priced. Gold in the treasure trove found in England last year is worth today about the same thing it was when it was buried 12 centuries ago. It cannot regress to the mean; it is already there.

On the buy side, we are looking for an investment that is despised...not one that is admired. And so, back to Japan, where equities peaked out in 1990 and have been going down ever since. While the Japanese government wanders among the stars, the private sector has dropped back to the ground. Or beneath it. Tokyo-listed stocks have lost 75% of their value, wiping out an entire generation worth of growth. Many Japanese companies sell for less than the value of their current net assets.

And now, after twenty years, Japan's private businesses are finally benefiting from the stimulus programs. The government will go broke, but by destroying its own credit, Japan cuts the value of the yen and boosts profits for its exporters. Toyota's local labor costs - in dollar terms - fell 5% in the last three months. And by the time the catastrophe is complete, Japan's businesses could be the most competitive in the world. One way or another, 10 years from now, we'll wager that Japanese stocks will be higher...if only relative to the rest of the world's equities.

But of all the whack that investments might be out of, US Treasury debt stands above them all. For the last 27 years, the US government's cost of borrowing has gone down. But while bond yields declined, the quantity of US debt exploded. Official, on-the-books debt trebled. Include off the books, unfunded financial obligations and the total reaches $118 trillion - 8 times GDP. And now the explosions come every month. As the depression continues, US deficit-financing needs could rise to $150 billion every 30 days. So far, the bond market has absorbed the shocks with good grace. But sometime in the next 10 years, the angels are bound to be proven right.

Sell US Treasury bonds. Buy Japanese stocks.

Regards,

Bill Bonner
for The Daily Reckoning Australia

• Will Gold Have Another Great Year in 2010?
• Trading Airline Stocks in an Energy Bull Market
• Investors Better Off Investing in Anything but Stocks
• Paying More Than 3 Times as Much for Gold
• Typical Japanese Investor Would End Up With Less Than What He Started With

According to theory, the markets know more than any single investor, analyst or economist. In theory, the markets know everything there is to know. In theory, the markets are always right.

But what the heck? This is the same stock market that signaled clear sailing ahead ten years ago. Soon after, equities hit an iceberg. They sank for the next decade.

Here at The Daily Reckoning, we had our own views. At the beginning of the '00s, we told readers to sell their stocks. We were right. The stock market was wrong. Heh heh.

So, who ya gonna trust now? The stock market... Or, The Daily Reckoning?

Who knows... Maybe we're wrong this time, but we see another 10 years of trouble coming. Two years ago, the credit cycle peaked out. After half a century of adding debt, the private sector had had enough. Borrowing turned down. Last November, it registered its 10th month in a row of declines, something that had never happened since they began keeping records after WWII.

Consumer spending has held up surprisingly well. But with credit contracting and unemployment high and rising, it can't continue.

Small businesses create jobs. But who wants to take the risk of funding a small business now? Not the banks. And the capital markets are closed off to small businesses. You have to have a big business - preferably one that is dying... Then, you can get all the money you want from Wall Street and the feds.

Since the downturn began two years ago, 7.5 million jobs have been lost. There is no sign that they will be found anytime soon. Jobless people do not spend a lot of money. Ergo, you can't really expect an economic surge until people get jobs.

When will that happen? Possibly years from now...maybe 2...maybe 5...maybe 10...

Yes, dear reader, we are in a depression. It is a period of adjustment...of correction...of de-leveraging...of paying down debt. And there's not much the feds can do about it - except disguise it...delay it...and make it worse.

The government can spend money. The government can inflate the currency. But it's neither government spending nor inflation of the currency that makes an economy healthy. If inflating the currency could make an economy prosper, where did Zimbabwe go wrong? And if government spending could boost an economy, what did Cuba do wrong? Or Venezuela? The two-bit, banana republic economies are almost all burdened by too much government stimulus. The feds tax too much, spend too much, borrow too much and inflate too much. Instead of doing their jobs - enforcing property rights, protecting people from crime, and staying out of the way - they meddle and spend. The president gets a fancy house and lots of security guards. And the economy rots.

Of course, we could be wrong about what is happening in the US. But our guess is that the stock market is wrong instead. Stock market investors anticipate a return to 'normal.' But the normal they're looking at is a very unusual credit bubble that blew up and can't be mended. The real normal is what we're getting. And the real normal is a world where bad stuff happens. Investors make mistakes. Markets make mistakes. Often, they are misled by their own financial authorities, such as Ben Bernanke. The US Fed chief meddles in the economy and distorts the picture. Investors look, but get the wrong idea.

Our guess is that stock market investors are seeing the distorted picture caused by the feds' meddling...not the real picture. They look. They see low interest rates. They see stimulus. They see a stock market that seemed so friendly and so rewarding for so long that they can't imagine anything else. They see a government taking action...and making things better. They read Thomas Friedman and think the 'political class' can fix whatever problems it encounters.

But in the real world, the political class is a life-threatening parasite. Allow it to grow large enough and the host - the private economy - will shrivel up and die.

And in the real normal world, markets go up...and then they go down. We are in one of those periods of decline. We are in a depression, with a growing, parasitic political class. This phase won't end any time soon.

Gary Shilling is probably right. He says to buy Treasury bonds and the dollar. They're both probably going up this year.

Why? Because we are in a depression. And when investors finally realize it they will seek safety. They will buy US Treasury bonds, raising prices and lowering yields. Those Treasury bonds are in dollars, by the way. Investors will want dollars.

There are two main emotions that drive investors - fear and greed. Lately, greed drives them to buy emerging markets, stocks generally, and commodities. Fear drives them to dump all their risky investments and head for cover. They believe cover is found in the dollar and in US Treasury bonds - traditionally, the world's safest credits.

"Ireland has changed so much," said a colleague at last night's dinner. He was speaking early in the evening. Later, we went to Henry Downs' place...where the #9 whisky is as smooth as a baby's derriere. We can't remember what happened after that.

"The Irish had big families. Everyone had five or six children. We were a big exporter of people. People were our major export. And of course, the world is full of mics and paddies. America, Canada, Australia, New Zealand...but there are also a lot of Irish in Argentina.

"Birth control was illegal. I remember when I was 16...I had a friend who wanted to sleep with his girlfriend. Since I was tall and looked older he asked me to go into a pharmacy and buy condoms. It was so awkward. I waited until there were no other customers in the shop. Then, I went in....trying to make my voice lower than it really was...and asked the middle aged woman behind the counter for condoms. It was so embarrassing. It's a wonder people had sex at all."

"People in Ireland are still funny about sex," said another Irish colleague. "My boyfriend and I 'lived in sin' before we got married. Everybody knew it. But 'living in sin' was not just a joke. People thought it was a real sin. They didn't really mind it, but they expected us to pretend we weren't sinning. So when my parents would visit we had to pretend we had separate bedrooms...even though it was obvious we were sleeping together.

"But nowadays, it's different. Now couples only have one or two children."

Regards,

Bill Bonner
for The Daily Reckoning Australia

• Everyone We Know Expects a Fairly Quick Up-move in Inflation
• A Nightclub in the Middle of Rural France
• US Economy is Some 11 Million Jobs Short of Full Employment
• Are Stock Market Investors Really Such Optimists?
• Stock Market Continues Its Recovery

These two giant mortgage lenders are poster children for the dangers of wrapping government guarantees around the credit markets. With help from the state-sponsored banking system, these two government-sponsored entities (GSEs) perverted the process of credit intermediation and artificially suppressed the cost of mortgage loans over many decades.

This perversion of mortgage finance explains why house prices grew faster than household incomes for roughly a decade ending in 2006. With the broad recognition that the GSEs were insolvent in late 2008, the artificial suppression of mortgage rates was about to come to an end. That is, until the Treasury and Federal Reserve doubled down on their commitments to throw good money after bad. Now, permanent manipulation of mortgage interest rates has become official government policy. The cost of this policy will be even higher federal deficits in the future.

Government guarantees temporarily hide risks, which results in foolish capital allocation throughout the economy. This game can last until the activity collapses under its own weight (like housing in 2007), or until the government itself runs out of financing options at affordable interest rates.

Just like Medicare policies influence the practices of health insurance companies, Fannie and Freddie mortgage-backed security (MBS) guaranty policies influenced the underwriting behavior at mortgage brokers. Therefore, no one should be surprised that mortgage brokers fudged numbers to shoehorn borrowers into "conforming" mortgages. These brokers generated huge profits by unloading massive amounts of underpriced credit risk into the Fannie and Freddie MBS pipeline.

Mortgage expert Mark Hanson described the triumph of automated mortgage underwriting over prudence in a December 2009 issue of the Mortgage Pages:

During the bubble years, the GSEs looked at [debt-to-income ratios] secondarily to credit score, [loan-to-value ratios], and cash reserves as measured by liquid cash and 70% of retirement [assets]... During the bubble years, if the LTV was low enough and/or score and cash reserves high enough, the system would approve virtually anything.

Many lenders, especially the big banks, had...underwriting "trainers" that would go around to the various mortgage branches and teach underwriters how to "trip" the systems in order to achieve automated loan approvals when a declination was certain, or simply get fewer approval conditions on a loan that was borderline. Getting a loan approval out of...a borrower with a 100% [debt-to-income ratio] - with limited documentation required on the automated findings - was not uncommon.

The poorer-than-expected quality of the mortgages inside of the MBS that Fannie and Freddie guarantee will lead to hundreds of billions in credit losses. The frequency and severity of these credit losses over the next few years will take Wall Street by surprise.

These credit losses will blow huge holes into the GSEs' balance sheets, overwhelming their thin slices of capital several times over. When this capital vanishes, the US Treasury Department will float more government debt and use the proceeds to refill the capital shortfalls.

On Christmas Eve, the Treasury delivered a lump of coal to US taxpayers: It eliminated caps on future equity injections into Fannie Mae and Freddie Mac. Let's not kid ourselves. These capital injections are not "investments." No rational investor would be injecting equity into the GSEs right now. Rather than demand a reasonable risk-adjusted return, these injections will just keep the GSEs' loss-plagued balance sheets solvent.

Consider the situation by visualizing Fannie's and Freddie's balance sheets. Since the beginning of the financial crisis, the Treasury and Federal Reserve have teamed up to reinflate the assets and equity of these institutions. The Treasury pumped new equity (in the form of preferred stock) into them as needed, while the Fed used newly printed money to buy up the GSEs' debt and the mortgage-backed securities that the GSEs guarantee. Thanks to these shenanigans, the market prices of the assets on the GSE balance sheets appear to be holding up. But make no mistake; despite the Fed's actions, the real underlying value of these is being eaten away by credit losses.

On Jan. 12, Amherst Securities published a study on the estimated losses Fannie and Freddie will absorb as foreclosures flow through the credit loss pipeline in the coming years. Using a database of 29 million active prime mortgages from First American CoreLogic, Amherst estimates that the GSEs will ultimately suffer $448 billion in cumulative credit losses. Amherst explains the likely distribution of these losses:

These gross losses will be distributed across four categories - write- downs already taken by Fannie and Freddie and reflected in their loan loss provisions, future credit losses to be taken by Fannie and Freddie, losses absorbed by mortgage insurers, and losses absorbed by originators through put backs. Fannie's loan loss reserves total $66 billion: $57 billion for MBS guaranty losses, $9 billion for loan losses. Freddie's loan loss reserves total $30 billion: $29 billion for MBS guaranty losses, $1 billion for loan losses. The remaining $352 billion of losses will show up across the other three categories (Fannie and Freddie future losses, mortgage insurers, and originator put backs) over time.

If Amherst is accurate in its projections - which I expect, given the quality and independence of its research - then Fannie and Freddie have built allowances to cover a mere 21% ($96 billion divided by $448 billion) of the losses they'll ultimately have to absorb from the housing bubble.

It's no wonder the Treasury Department lifted the bailout caps on Christmas Eve; it'll be the only entity willing to plug the GSEs' deepening capital holes.

What does this mean for the markets? It translates into very bad news for complacent stock market bulls and junk bond junkies.

The lifting of the GSE bailout limits strengthens the case for rising Treasury yields in 2010. Rising Treasury yields are bearish for the stock market because higher yields offer better competition for investors' dollars. Rising Treasury rates also increase the cost of capital for all companies.

The elimination of limits on Treasury's capital infusion into Fannie and Freddie is a de facto nationalization. We'll see a gradual transformation of these hollow zombies into new branches of government. They'll implement the official agenda for housing, with little regard for prudent lending standards. This could severely degrade the creditworthiness of US Treasury securities.

The government will probably stick to its dishonest, Enron-style accounting; it won't officially consolidate Fannie and Freddie assets and liabilities onto the federal balance sheet, but many foreign creditors will. These creditors will demand higher rates to compensate for the rising risks of investing in US Treasuries...and that means bond prices will fall...eventually.

Dan Amoss
for The Daily Reckoning Australia

• Fannie and Freddie Say Goodbye to Veto
• The Two Pillars of the U.S. Mortgage Market, Fannie Mae and Freddie Mac, Wobbled Again Yesterday
• What’s Going to Happen to the Mortgage Twins – Fannie and Freddie
• Government Sponsored Enterprise Debt and Australian Banks, a Ticking Time Bomb?
• Fannie and Freddie: Playing With a Stacked Deck

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

• U.S. Bonds Better than Greek or Other Sovereign Bonds
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• It All Comes Down to Debt Again for NAB
• Everyone We Know Expects a Fairly Quick Up-move in Inflation
• Hyperinflation and the Dollar’s Monetary Destiny

Here at The Daily Reckoning we may hate the devil and renounce all his works...but we're betting on him anyway...

Let's begin with the headlines:

"Financials Slam Wall Street," says a headline. The Dow fell 92 points. Makes us think the financials didn't slam it very hard.

Gold rose. Oil rose. And the dollar sank below $1.50 per euro...another milestone.

As we reported yesterday, investors think the recovery is for real...and that it will boost up prices of commodities and stocks. The dollar, on the other hand, is chopped liver.

But we have a feeling that the devil is on the side of the dollar. Let's us explain.

"How Wall Street Will Kill the Recovery," is a headline at BusinessWeek.

Finally, everyone is catching on to how it works. The big banks take the feds' money...then they speculate with it ...or lend it back to the Fed for an easy 400 basis points of gain.

At Seeking Alpha, they're talking about "the return of Japan's zombie finance." Over at The Wall Street Journal they've talking about America's own "Zombie banks."

But these monsters are only reacting to the jolt of juice given them by the Dr. Frankensteins at the Fed and the Treasury. It has become very unprofitable to hold cash; the feds are creating more of it by the boatload. You get a minimal rate of return on cash...while other assets go up. And the feds can't stop...or change course...not without sinking the whole economy. They may talk about an 'exit strategy.' But the exits are blocked. Remember cash is created when the feds "monetize the debt" by buying US Treasury bonds. In order to exit...that is, in order to reduce the monetary base...they'd have to sell those bonds back into the open market.

Are you kidding, dear reader? After being the single largest buyer on the planet? Imagine what will happen to the bond market when investors realize that the Fed is selling! It's not going to happen. Instead, that $1 trillion increase in the monetary base is more or less permanent...and it's eventually going to turn up as inflation.

The feds have no idea what is going on. They consistently misunderestimate the devil...the market...and the economy. And they consistently misoverestimate themselves.

In short, the old timers were right. To them, an economy was a natural thing...like an eco-system...or a language. It followed natural rules...rules that no man could change. It was like a living organism. It needed to breathe in and breathe out. And like all things under heaven, it was subject to moral laws. Do the wrong thing and you (an economy...as well as an individual) will pay the price. You don't get what you want from markets...you get what you deserve.

This seemed intuitively correct to generations of economists. Not only that, it was proved correct time and time again. Each time people borrowed too much and spent too much money, they came a cropper.

You may ask: "How much is too much?" According to the record, compiled and analyzed by professors Reinhart and Rogoff, it's impossible to say exactly. One nation can support public debt of 200% of its GDP (Japan comes to mind)...another cracks up at 50% (think of Argentina). A man like Donald Trump can carry millions in debt...another goes broke if you lend him 20 bucks.

(At one point Donald Trump was the poorest man in the world. His net worth was negative by 10s of millions (we don't recall the figure). All over the world, hundreds of millions of people could have said: 'I'm richer than Donald Trump.' Even if you didn't have a dime, you were richer than The Donald.)

So, how much is too much debt? It depends on what you use the money for...how much you have in assets...whether your earnings are shrinking or growing...and a number of other questions. But while the answers aren't simple, the questions should still be asked: If you run up a debt, how are you going to pay it back? What will happen if you don't pay it back?

A professor at the University of Basel, Peter Bernholz, thinks he has the answer. He studied instances of hyperinflation. He believes that you get hyperinflation any time the government spends 166% or more of what it receives in revenues. This should set off alarm bells. The US budget is now about 170% of tax receipts.

The feds can't repay the record amounts they're borrowing - not without a major political crisis. They'd have to cut spending and raise taxes so dramatically it would cause a backlash. The parasites would revolt. It would probably unseat the ruling party and break the repayment plan. Generally, people prefer inflation...or default...to actually paying their public debts.

One way or another, however, the devil debt will have his due. Somebody is going to pay - if not the borrower...then surely the lender. There's a bullet out there. Someone has to take it.

But who believes it? The old economists are dead. John Maynard Keynes denied that debt mattered very much. Then, his successors forgot that it mattered. Dick Cheney told his party to stop worrying about it. And now a whole plethora of modern economists and politicians believe that the problem with today's economy is that there is not enough of it. Debt that is. They think the government should borrow and spend even more. To them, the whole secret to a healthy economy is how much money people spend. Yes, it's absurd, but that doesn't make it unpopular. People like spending money. And they welcome economists who tell them that they're doing the right thing.

Since Keynes, economists pretend the devil doesn't exist. They believe they are not part of nature...controlled by natural laws. Instead, they want to take control of nature. And the only way they can get a grip on economies is to break the boom-bust business cycle. And you can't do that unless you pretend that debt doesn't matter.

The trouble with real markets is that they are always subject to human emotions and human calculations. It is a quality that George Soros describes as "reflexivity." Markets act differently, depending on what people believe. And when the authorities try to turn their knobs and yank on their levers, it changes both what people believe and what they do - but not necessarily in the way the feds want.

It is much easier to manipulate speculative markets than it is to manipulate the real economy. Want to drive up prices? Just give speculators some free money to play with! Guarantee their debts! Bail them out of their stupid positions! That's what the feds have done. And that's why the banks - the recipients and conduits for the free money - are making profits. Goldman allocated $527,000, per employee, in compensation for the first 9 months of this year. An increase of 46% over last year.

Gold, oil, copper, stocks - all are in government-induced speculative booms. But the underlying economy is harder to move. In order to get consumers to spend, the feds have to put money into their hands...and raise prices so consumers will want to get rid of it, rather than hoard it. But that is proving very hard to do.

Why? Because of the debt. Consumers have to pay down their debt. They have to cut back. They have to spend less. So, the economy shrinks.

And now The Wall Street Journal is talking about another downdraft in the housing market. It could get "even uglier" it says. Why? The mortgage debt that still have to be reset and rescheduled. Apartment rents are falling as unsold units are put up for rent.

Sales at luxury stores go down as consumers work their way back down the price chain. Why? They have to spend less as they pay off their debts.

Yes, you can ignore debt...until you go broke!

Bill Bonner
for The Daily Reckoning Australia

• Investment Banks Making Money Thanks to US Government Bailouts
• Feds’ Plan is to Reflate the Economy
• Why Do Men and Women Want Money and Power?
• What’s the Best Way to Get Through a Debt Crisis?
• Dodge Taxes Legally… Become Treasury Secretary

Some of his field commanders, however, noted that they were picking up very few prisoners. Normally, an army that is beaten throws off many discouraged and confused soldiers. Since there were so few, the commanders reasoned that the French army was still intact; it was merely retreating in good order and could turn and surprise the Germans at any time.

The commanders were right. France's aging general, Gallieni, who was in charge of the Parisian garrison, realized that the Germans were making a fatal mistake. By pursuing the troops down the Marne, rather than attacking Paris, they exposed themselves to a counteract from the city itself.

"Gentlemen," he is said to have said to his staff. "They offer us their flank."

The French took the offer. They attacked. Using thousands of taxicabs, they moved troops to the Marne Valley as fast as possible and caught the Germans unprepared. The Battle of the Marne turned the German army around and ultimately cost them the war.

We bring this up now because we have a feeling that the dollar is not broken. It is merely retreating in good order. At $1.49 per euro, it is not at the record low you'd expect after so much negative press. And it is not giving up more ground. Instead, it is holding.

Yesterday, the dollar price of stocks went down. The dollar price of oil and gold went down too. The dollar has not yet counter-attacked. But the dollar bears are vulnerable. We wouldn't be surprised to see them hit hard in the weeks ahead.

Of course, in the very long run, the dollar bears will prove to be right. We have little doubt that the coin shooter who finds a cache of US Treasury bonds in the year 3,400 - like Mr. Herbert in 2009 - will have tears in his eyes. Though perhaps not for the same reason.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Monetary Inflation is Driving Up Prices
• The French are Feeling Pretty Smug
• Eurozone Drops GDP Bombs
• America’s Service Industry is responsible for Low Wages
• The Swiss and the Rich

- Edward Gibbon

Warren Buffett famously says that people do not make money by betting against the US economy. But two years ago we decided to take a chance.

"We are short the United States of America," we announced from the comfort and safety of our headquarters in London. "Sell its stocks. Sell its bonds. Sell its money. Sell its real estate. Sell the equity. Sell the debt. Sell everything."

What we saw was an over-stretched empire getting ready to snap. But we were also allowing ourselves to be lazy. Rather than deconstruct the capital structure of the world's largest economy, we decided to sell the whole damned thing.

All Hell broke loose in September 2008. Since then, US stocks have gone down about a third. Real estate too. Unemployment has doubled. Consumer prices are going down at the fastest rate since the '50s. And the economy is in the worse recession since WWII.

Meanwhile, Americans' per capita wealth has fallen from $172,000 in September from $212,000 two years earlier. And the UN reports that the quality of life in America has gone down too...from #5 on its list in 2000, it fell to #13 in 2007. No doubt it is below #20 now.

Buffett has lost billions betting on the US economy while our gold positions are handily up; gold was the most profitable major asset over the last ten years.

So you see, we were right; America was a sell two years ago.

And now it is the dollar that is falling. It's gone down 12% in the last six months - a huge move for a major currency.

"Asia tries to slow dollar fall," is the lead story in today's Financial Times.

Today, a buck and forty-seven cents will buy you only 1 euro. Ten years ago, you could have gotten a euro for less than a single dollar. A falling dollar makes imports more expensive, say analysts...raising the cost of living in the homeland. But you wouldn't know it from walking around on the streets of Miami or Las Vegas. You can get a house at 50% off its price three years ago. As for the breakfast special - for less than 3 euros you can get enough food to kill a Pakistani.

By European standards, America is cheap.

"Europeans again interested in Florida houses," says a headline in The New York Times.

House prices are down 30% to 50%. The dollar is down about a third too. That makes the United States a bargain.

But is the United States of America about to become even cheaper?

One thing we were wrong about when we issued our 'sell America' call two years ago was US debt. Treasury bonds have resisted the general downward trend of things with the stars and stripes on them. Bonds have not gone down; they've gone up.

Private households are buying them for their retirements. Banks are buying them for risk-free profits. Speculators are buying them in anticipation of deflation.

David Rosenberg:

"The big story yesterday was the further massive $12 billion decline in outstanding consumer debt in August - the consensus was looking for an $8 billion contraction. This was the seventh month of debt retrenchment in a row. In other words, the tidal wave of the credit collapse continues unabated, and this is the primary reason why bond yields are still in a fundamental downtrend.

"Over the past year, consumers have run down their debt by a record $113 billion (and this does not include mortgages). This is an absolutely epic shift in household attitudes towards credit and discretionary spending."

Americans are saving. And they're buying US Treasury bonds. (More below...) But how safe is their money? Is it a good idea to buy US debt now?

On Wednesday, Latvia tried to raise a trivial amount of money. It offered $17 million worth of 6-month bonds. How likely is it that Latvia will default before Easter? We don't know, but investors judged it not worth the risk. Not only did the bond auction failed, it failed with no bids.

That's what happens when lenders lose faith in a government. They refuse to lend it money - except at high rates of interest. But the high rates of interest work like a noose on the neck of a cattle rustler. They block the vital flow of oxygen - not to mention breaking his neck.

Note that the US federal government is still functioning like an empire at the peak of its power. The Pentagon is still rustling up trouble all over the world - at a cost of trillions. US government employees are growing more numerous and richer - with twice the annual incomes of the private sector. And the Obama Administration - apparently unaware that the total unfunded debts and obligations of the federal government have soared to nearly $120 trillion - is considering new ways to get rid of cash.

Remarkably, investors still lend the US government money - asking only 4% annual yield on a 30-year loan. As for 91-day money, they practically give that to the feds for free; it sports only a yield of 0.066%.

This will surely be a point of puzzlement for the financial historian of the next century. It is certainly a point of puzzlement for us.

Yesterday, gold hit a new record at $1057. Doesn't gold go up when inflation rates rise? And don't bonds go down when inflation goes up?

So why are people buying bonds with such puny yields?

There is a lot of whispering in this market. Gold is trying to tell us something. Bonds are trying to tell us something. The dollar seems to have something on its mind too. Stocks are just babbling.

If gold is trying to signal that inflation is coming, the bond market is not paying attention. Bonds seem to be saying that it is deflation we should be worried about; but the stock market doesn't seem to hear.

And there's the dollar. The greenback is in the same choir with stocks and gold, as near as we can tell. They all seem to be chanting about inflation coming back.

But what if they're all wrong?

Just look at what is going on in Washington, if you can bear it.

The feds have a budget that anticipates inflation and growth. Spending is supposed to remain flat until 2013. Tax receipts, which are no higher today than they were 10 years ago, are supposed to rise, gradually filling in the Grand Canyon of deficits. The number crunchers think we're headed back to the Reagan years - when the tough-love policies of the Volcker Fed squeezed out inflation and created a real boom. Then, tax revenues rose 9% per year between 1984 and 1989.

How likely is that today? Not very. Instead, what is likely to unfold is a deflation story. Instead of staying flat, federal expenses are likely to rise as one failed stimulus gives way to another failed stimulus. Then, instead of going up, tax revenues will go down...digging an even grander canyon between out-go and income.

Then, or long before, there will be a panic out of bonds, the dollar, stocks - practically everything. Everything goes down!

At this point, the US will be in about the same situation as the Roman Empire as it approached retirement. Expenses kept rising. Rome had to pay the Blackwater-type military contractors of the era...in addition to keeping Roman mobs supplied with food stamps and unemployment benefits...while its tax base fell. Gradually, the empire lost the ability to defend itself.

When Edward Gibbon began his history of Rome's decline and fall, Roman real estate had probably been in a bear market for at least 1300 years. Rome's population fell from over a million to under 20,000. Politically, Italy had broken apart more than 1,000 years before Gibbon was born, and it wouldn't be put back together again until nearly 100 years after he was dead.

It's far too early to write the story of America's decline and fall. That job will fall to some future historian, perhaps seated on the ruins of the Lincoln Memorial, wondering how people made such a mess of things.

Our guess is that he will come to the same conclusion we have: Stocks? Bonds? The dollar? Investors should have sold them all!

Bill Bonner
for The Daily Reckoning Australia

• America’s Decline as a Great Empire
• Deleveraging Will Give Us a Bout of ’30s-Style Deflation
• Warren Buffett Says American Economy is a Shambles
• Mistakes Made By America Are the Same Mistakes That Empires Make
• The Major Difference Between Rome and the U.S. – Electronic Transfers

Two important things happened yesterday, both of which cast a crimson light on things.

First, the Dow dropped again; it has only gone up one of the last 7 days. It went down 203 points. Could be nothing. Could be something big...the beginning of the long awaited 'next leg down' for the bear market...the opening day of a bloody Red October.

Charts of oil, commodities, copper, the dollar, and Treasury bonds tell us the same story. The greed investments are topping out. The fear investments are headed up.

What's a 'greed investment?' It's anything that benefits from an improving outlook for the economy and inflation - oil, commodities, and stocks, mainly.

What's a 'fear investment?' It's something that goes up when people begin to suspect the boom is a phony - namely the dollar and US Treasury bonds.

The dollar is rising. So are Treasuries. Yesterday, 30-year US Treasury bond yields fell below 4% for the first time since April.

And what about gold?

Well, that's the other important thing that happened yesterday. Gold held above $1,000.

So what?

So what?? Well, dear reader, you are in a prickly mood this morning, aren't you?

This is important because gold could go either way. Gold is a refuge in times of fear - especially when people fear inflation or a falling dollar. Gold is also a target of greedy speculators sometimes, even when the going is good. According to a study done by the World Gold Council, you never know what gold will do. That study was a great comfort to us here at The Daily Reckoning; we thought we might have missed something. But no. We may not know what gold will do, but neither does anyone else.

Looking around, we see no sign of consumer price inflation. So gold's recent rise must have been driven by optimistic speculation - along with oil and stocks. Now, when oil and stocks go down... we have to wonder whether gold will go down too. The answer, given yesterday, was what we expected - yes, but not as much.

There's substantial risk in gold as well as stocks. The ultimate low for the Dow should be below 5,000. That is, let's say, about a 50% haircut from current levels. And let's assume that gold does what it did yesterday...let's suppose that it goes down only 40% as much as stocks. That would still be a drop of 50% of 40%, or 20% - to the $800- an-ounce level.

If you would be gravely upset by a drop of that magnitude...you probably shouldn't buy gold at this level. And, of course, you should have sold your stocks already. Stick to cash - and gold, if you're long-term oriented - until this next phase is over.

The economic news was mixed, as usual...with nothing to make us think that our basic outlook is wrong.

On the optimistic, bullish side...consumer spending rose in August. Pending homes sales went up too.

But on the pessimistic, bearish side... "September auto sales plunge," says a Reuters headline. Yes, auto sales drove off a cliff last month - just like we said they would. GM reported a 47% drop.

What happened? The clunkers program was an economic fraud. Like all attempts to boost consumption, it merely shifted sales from the future to the present (now the past). Which is a big reason why August consumer spending looked good too.

But wait a few weeks for the September consumer spending numbers. Especially if the stock market continues to fall... Then we'll find out how sustainable those retail sales numbers really are.

As you know, here at The Daily Reckoning headquarters...in the building with the gold balls on the south side of the Thames...we are often accused of 'pessimism.' We deny it. We're optimistic about the fate of mankind. But we are pessimistic about many of his current pretensions - such as health food, enlightened central banking, contemporary art, mass education, global climate control and progressive democratic government.

But maybe we are wrong to be optimists. Pessimists always have the last laugh - when the optimists die. "I told you so," they say, under their last breath.

Bill Bonner
for The Daily Reckoning Australia

• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Is Gold Going Up Because People Fear Inflation?
• Abandoned Shopping Malls to Follow Abandoned Houses
• China Stepping Up Purchases of U.S. Treasury Debt
• September is the Best Month for Gold

About twenty minutes later we found ourselves tucked away in Café Paradis reading about the latest deep-water oil find off the coast of West Africa. The positive drilling results in the Venus well off the coast of Sierra Leone are not far from the Jubilee field Ghana, which is Africa's largest deep-water oil field. It could be, so the experts say, the next big off-shore oil bonanza.

Jubilee...Venus...there's an air of love and triumph in the oil exploration business now, isn't there? At least off the coast of Africa, which, if you don't mind political risk, is one of the great prospective areas for oil in the world. The oil is probably there. But you'll just have to accept the risk that comes from operating in that part of the world.

As an aside, we wonder if there's really any more political risk to operating an oil business in Africa than, say, buying U.S. Treasury bonds from a bankrupt government that's increasing its deficit spending as we speak. Risk is risk, even if it's dressed up in a nice fancy greenback with a respectable looking dead president on it.

Later when we got back to our hotel we managed to see that Woodside Petroleum is involved in the Venus well. Woodside's Sydney-listed share was up just over 1.5% in Thursday trading. The company isn't yet at a 52-week high. But it's moving.

If he were here, we'd ask Lord Swarm where the Slipstream would take us if we tucked in behind WPL at just this moment.

The other Aussie story that we spilled coffee on while scanning our bleary eyes over the pink pages was that BHP says China's recovery is going to make steel demand, "soar." "BHP Billiton yesterday predicted global steel demand would double over the next 15 years as the world's biggest mining group said the 'upswing' already evident in China would be followed by a rebound in growth from developed nations in 2010."

Airplanes ARE kind of time machines. But after reading this story your editor wondered if he had been transported back to 2003. That's when we last lived in Paris and first felt our first flush of desire at learning of BHP's exposure to the China story. It certainly was a torrid three next years.

But is the story as good now-or even better-nearly six years on? We'll have to sleep on it and get back to you on Monday, once the jet lag subsides. Until then, we'll expect stocks, oil, and gold to keep marching up. That seems like what they want to do right now.

Paris on Thursday was colder than Melbourne when we left on Wednesday. How disappointing. And even the old neighbourhood had fallen on harder times. The bakery where we used to buy our breakfast pastry on Rue St. Martin has been replaced by a Subway Sandwich Shop. A Starbucks is nearby.

But the real surprise is that the scaffolding has finally come off the Tour St. Jacques off the Rue de Rivoli. For all we know this could have happened years ago. It's been several since we were in Paris. But for all the time we were here, the old tower was shrouded in scaffolding as it was being restored. Today, in the grey gloom, it looked just like we thought it would: a big stone tower with lots of carvings on it.

We'll have a closer look tomorrow. And get back to you on what Australia looks like from France. Until then...

Dan Denning
for The Daily Reckoning Australia

• The Offshore Drilling Boom Creates Demand for Infrastructure
• Water Usage by Big Companies
• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Riding the Bear & Deep Drilling in Australia
• Peak Oil – The Rewards