"What?" we replied to one of our analysts this morning.

"He's the only Storm Trooper named in the Star Wars movie. I bought a card board cut out of him pointing his laser rifle at you. It was on sale the Science Works exhibit. I've put him behind your desk to remind you that you're under the gun."

True enough. It's not just your editor under the gun, though. What's at stake this week is whether attempts by governments and central banks to prevent more credit writedowns have succeeded. If they have, it could prevent the further transmission of the credit crisis from the financial sector to the real economy. And for investors, it could kick off a Great Releveraging.

Are we changing our tune, then, about what to expect from markets? Not one bit. But the question now is timing. The collapse of 2008 was so severe because of the sudden reduction in leverage in the financial sector. As assets fell in value, the most highly leveraged firms (or lenders who raised money by selling debt) went out of business.

This kicked off a chain reaction in which other market players were forced to sell assets and preserve capital. Banks preserve capital by not lending. This is how the credit crisis "jumped" from the financial sector the medium and small businesses (those not big enough or politically connected enough to qualify for government bailouts). And from businesses the deleveraging crisis went straight to households, who began saving more and cutting back spending.

And now it comes full circle. When households cut back, it eats into corporate profits and bank profits. Households with members who've been fired get behind on bills. Securitised credit card receivables, car loans, and mortgages - a large chunk of bank assets - start to go pear shaped. And banks face more credit writedowns, accelerating the cycle.

This is the cycle the Feds and global monetary authorities set out to short circuit this time last year. Their main objective: increase asset prices to stabilise bank balance sheets and prevent the spread of the credit crisis. How did they do it? TALF, TARP, CAP, the suspension of mark-to-market accounting rules, and the maintenance of low interest rates (in the States especially).

All these clearly did support asset prices, and especially allowed banks to post a quarter two of quarter over quarter earnings growth. This has created the appearance of stability. But what has not improved one bit is the quality of those bank assets purchased with borrowed money. There will be more writedowns to come. But when?

We should entertain the possibility that the Feds can support asset prices for some time. Take Australian housing for example. This week the Federal government announced that it would chuck another $8 billion in taxpayer money to purchase residential mortgage-backed securities (RMBS). Treasurer Wayne Swan says he's doing it to support "the home lending market."

We'd say he's doing it to keep money flowing into the housing sector so builders stay busy, banks stay profitable, and house prices stay high. Remember, this subsidy to non-bank lenders in the RMBS market is there because other investors won't fund these lenders. And why would they when the government is happy to put your money on the line.

The government says the securities are collateralised by high-quality residential real estate. But that's what pretty much anyone who was hawking this kind of debt said in the U.S. for the three years of peak mortgage issuance. This is how real estate - traditionally a local industry where prices vary from place to place - becomes a national market - through the nationalisation of the mortgage bubble. A national mortgage bubble can inflate house prices across the board-making the entire country vulnerable to higher interest rates and/or a credit crisis.

Here you see the public sector adding debt while the private sector scales back. Also, in Australia, there is still widespread public belief that house prices only ever go up. That means the government can support lending because borrowers are still borrowing. This just makes the inevitable house price correction much more devastating. The borrowers with the smallest margin for error are going to be hurt the most.

Here's something else to think about: what happens when the stimulus spending dries up? Treasury Secretary Ken Henry says that the economy could lose another 100,000 jobs and that the withdrawal of stimulus spending will shave 1.5% off Australian GDP in 2010. This is another way of saying the peak effect of the stimulus (in terms of supporting both consumer demand and employment) was in middle two quarters of the year.

So how will Aussie consumers and businesses behave when the stimulus is withdrawn? Did the Rudd government give the economy just enough free money smack to keep its credit high going? Or will the comedown be just around the corner around Christmas? If they're cautious, Australians will put away their wallets and cut up the credit cards and reduce spending growth to match income growth. The retail sector and retail stocks will be hit hard.

There's one other big question for investors heading into the end of the year. We know the government can support some sectors more effectively than others. Big ticket items like housing and cars can be subsidised with tax rebates or, in the case of housing, with a fresh injection of credit to support politically connected non-bank lenders in the RMBS market.

But you have to reckon the economy boosting effects of supporting the housing market are limited. The main beneficiaries are the banks and the builders. Granted, if you're a politician, those are two important constituencies to keep happy. But what about the rest of the economy?

The basic question is how much of it will stand on its own two feet once you remove the stimulus. The stimulus, the FHOG, the government backing of the RMBS market...these are all attempts to revive an economic growth model that's dependent on asset inflation and credit bubbles. That's the model that led to the bubble that led to the bust.

Papering offer the holes blasted in bank balance sheets by the credit crisis seems to have worked in terms of restoring confidence. Call it a successful psychological operation by the government spin doctors and their buddies in the media and banking. The whole purpose of the operation was to appear to recapitalise banks to healthy levels. But really it was to prevent the banks from having to take further credit writedowns, which itself feeds the process of forced asset sales, declining asset prices, and more household deleveraging.

One immediate risk to watch for is Australia's resource export industry. Export volumes are down year. But for the largest export categories, last year's contract prices are still in effect. Looking forward, 2010 could see lower export volumes AND lower prices for bulk commodities like iron ore and coal (especially if Chinese inventory restocking is complete). This would make the current valuations on resource earnings look pretty generous. You'll read more this week on which sectors are going to thrive and fail in this Great Releveraging.

Back to gold and the dollar and the new world currency order. A simple question: what was all the fuss about last week with a new reserve currency anyway? Here is an answer. If OPEC demands payment for oil in something other than U.S. dollars, then people who buy oil (and who doesn't?) have to stockpile the other currencies in which oil is priced and traded. That would be pretty tough on America.

To support its oil appetite, the U.S. would have to buy the currencies in which oil is priced. It couldn't use good old greenbacks. How do you buy foreign currencies?

Well, you can sell your assets (gold, real estate, stocks) and use the money to pay for oil. This is what Australia does. Or you can borrow in a foreign currency (did anyone say future Chinese bond market?) It's also possible you can use earnings on your foreign-owned assets - provided those assets generate enough money to support your oil habit.

These are all options within the free market system. The main point is that all other things being equal, you have to sell something to pay for something. This is why the foundation for economic health is always wealth production, not consumption. Production creates the goods that facilitate the trade that creates the profits to increase purchasing power for the things you don't produce.

But outside the free market system, you could opt for just taking the oil by force. By that we meant that should the U.S. be put in the position of having to pay for oil with new borrowings or asset sales, it might take the geopolitical path of least resistance and resort to a good old fashioned overt resource war. The declining Empire will strike back with its principal remaining asset, its military.

Likely candidates for an oil war? Not Iran. It's too far away. There are too many U.S. troops in Iraq and Afghanistan that would become targets. And the effect of a Middle East war would be too destabilising on oil prices. But Venezuela, on the other hand, is much closer to home.

Granted, comrade Obama is a peace maker. He was a won a price for it. Peace be upon him. And it would not seem like he's not likely to attack his good friend Comrade Chavez.

But if the current president flounders in the fiscal morass he finds himself in, he'll be a one term savior. Some pundits are already calling him "America's Gorbachev." He's the man who will preside over the swift fall from grace of a Superpower.

There will be no second coming (term). And that leaves room for a challenge from a more hawkish member of his own party (Hillary Clinton) or a populist Republican with a handy doctrine of liberty within the hemisphere (let's call it the Palin Doctrine). If Obama is America's Gorbachev, who is America's Putin? That's what Glenn Reynolds at www.instapundit.com is asking.

Naturally all of this is pure speculation. But our main point is that the oil game is not just a currency game. It's a power game. And it's silly to think the U.S. would relinquish its control over the oil market so easily. There will be a fight.

Not that the U.S. could maintain the reserve currency status quo by force. But sooner or later someone at the policy level in America is going to realise that once the reserve currency status is lost, the country loses a huge strategic and competitive advantage. Its standard of living, already in major decline, would face a major body blow.

Just how American policy makers plan on maintaining that advantage is yet to be seen. Of course maybe they don't plan on it at all. The Empire could be so narcissistic and full of false confidence that few people fail to see the inevitable chain of events the country faces. You'll just get more spending and more chest-thumping and more fiddling. Or more war.

Dan Denning
for The Daily Reckoning Australia

• Banks Could Face Larger Asset Writedowns and Losses than IMF has Modelled
• Gold Sales Cost Europe’s Central Banks Billions
• Biggest Factor Affecting Consumer Price Inflation is Growth in Bank Credit
• Everyone is Busily Debasing Their Currency
• Shadow Banking System: A Murky World of Credit, Securitisation and Derivatives

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

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

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

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

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

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

M.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Dan Denning
for The Daily Reckoning Australia

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

And now back to the financial markets....

Go you little Aussie mortgage bubble! The value of new mortgages grew in May by 2.2%, according to the Australian Bureau of Statistics. For the month, investors boosted their demand for new mortgages at a faster clip than people who intend to live in the house (owner occupiers). That doesn't sound like a bubble at all does it?

Two other items of note in yesterday's housing numbers. The First Home Buyer's consolidated their position as the most important group propping up Australian house prices. First home buyers increased their percentage of total owner-occupied mortgage demand from 28.6% in April to 29.5% in May. Nearly a third of all demand for new mortgages is coming from new buyers sucked in by the grant. Hmmn.

One final note. The average loan size for the first home buyer was $281,000. That was actually a $3,400 fall from the month before. But it's still $14,400 higher-or about 5%--than what the average loan size of all the other borrowers in May ($266,900). Max out your borrowing at the low point of the interest rate cycle. Hmmn.

Moody's economist Matt Robinson told a reporter that, "The policy stimulus from the Federal Government and the central bank has helped boost the housing market, offsetting the deterioration in the labour market conditions that would otherwise subdue the willingness of people to purchase houses...This is a 'prime example'' of monetary and fiscal policy working."

That statement seems like a 'prime example' of getting the analysis absolutely wrong. We'll explain why in a moment. But first, a word about abductions.

What the heck is going on in Shanghai? Chinese police have detained Rio Tinto iron ore executive Stern Hu on suspicion of "espionage and stealing state secrets," according to Bloomberg. Hu hasn't been charged with a crime yet. Three other Rio workers who are also Chinese nationals are being held.

Incidentally, the Age's Matthew Murphy is reporting that Chinese steelmakers have agreed to a 33% cut in iron ore fine prices and 44% for lumps. "The deal would break a tense nine months of negotiations between the Australians and the Chinese, which had allowed the June 30 deadline to pass while refusing to budge on their demand for a price cut of up to 45 per cent," Murphy says.

Let's recap. In late March, Treasurer Wayne Swan knocked back China Minmetals' bid for 100% of Oz Minerals based on the proximity of Oz's Prominent Hill gold and copper mine to the Woomera weapons testing range in South Australia. Then in early June, Rio Tinto abandoned its offer to sell an 18% equity stake to Chinalco and instead raised the money from shareholders and a joint venture with BHP Billiton. And finally, the Aussie ore producers refused to give Chinese steel makers a larger discount this year than customers in Korea and Japan got.

So perhaps there's some hardball going on now? There are more than just business interests at stake in the relationship between Australia and China. There is national interest too. Interesting times, eh?

Let's quickly get back to that nonsense from the Moody's economist about policy stimulus 'working' by supporting the housing market. It could be a simple case of diagnostic failure. He said the policies are, "offsetting the deterioration in the labour market conditions that would otherwise subdue the willingness of people to purchase houses." But is this true? And if so, is it something to celebrate?

First off, throwing money at people to buy a house when they are at risk of losing their job doesn't seem like a good policy at all. It seems reckless. It also seems like the height of stupidity. But the larger issue is whether you can correct a problem if you don't really understand its causes.

The correct answer would be, "no." The policy responses inspired by John Maynard Keynes call for the government to run a deficit and spend money that households and businesses will not. But this response assumes that aggregate demand (household and business spending) has fallen for no good reason at all and that all the government has to do is restore confidence (by stimulating the appearance of health) and everything will be fine.

Balderdash! The problem isn't that demand has fallen unreasonably. It's that credit rose too much. The economy needs to walk itself back to more production (creating value) and less credit-financed consumption. Recessions aren't caused by too little spending. They're caused by spending gone wrong in a credit boom (mis-allocated capital).

In his latest Gloom, Boom, and Doom Report Dr. Marc Faber says, "This is where I have the greatest problem with US economic policy makers [ed note. We'd add Australian policy makers to the mix]. I don't think they have ever recognised that the excessive, credit-driven expansion of the US economy was unsustainable in the long run and that, sooner or later, the current crisis was inevitable. But not only that!"

"Now that we all know that the monetary policies implemented after the Nasdaq bubble burst in 2000 led to the current crisis, US economic policy makers are attempting to restore economic growth through essentially the same policies; the difference, this time, being that gigantic fiscal deficits are also being created."

To be fair, not ALL Aussie policy makers are making the same mistakes. As we reported yesterday, Glenn Stevens seems to know that in a balance sheet recession, the way back to recovery is to patiently rebuild the balance sheet on a foundation of solid assets and reduced debt. That's the course he encouraged businesses to take.

It's Australia's government that has us worried, and it's both parties frankly. The worse the recession gets (it IS a recession and it will probably get worse, we reckon) the more tempted (and forced) the government of the day will be to borrow more and more and run the deficit higher and higher. This won't be good for confidence in Aussie assets.

Speaking of which, Faber also had something to say about the on-going feud between inflation and deflation. "Asset markets," he wrote "are buffeted by recurring waves of inflationary and deflationary expectations and I'm afraid we might now run again into a bout of deflationary fears. But unlike the deflationists, I don't expect new interest rate lows in this cycle."

"The interesting part about all this is how the various asset classes relate to each other. Equities and commodities seem to move up at the same time (driven by rising inflationary expectations and growth expectations), while bonds and the US dollar move down (the pattern since March 2009). But, when deflationary expectations increase, the US dollar and bonds strengthen while commodities and stocks decline (the patter of 2008)."

If Faber right and the deflationistas have the upper psychological hand, bond prices and the U.S. dollar go up and stocks and commodities will go down. For Australia, you'd probably see a weaker Aussie dollar versus the greenback and lower stock prices too. Meanwhile, the government will try to restore growth by running large fiscal deficits which may stabilise the economy a bit, but a lower level of output (as businesses stay on the sidelines with investment spending).

So how much lower could stocks go? Faber thinks it will be a few years before stocks make new lows (below the 2003 levels, we assume). He says stocks were oversold in March but overbought in June. Stocks are now priced for an economic recovery that looks increasingly illusory.

Two other things from the good Doctor. He expects to see rebounding corporate profits as businesses begin to reap the earnings benefits of cost-cutting and deleveraging. They will be coming off a low base anyway. So he may be right to consider the dismal upcoming profit season as a contrarian nadir.

The other interesting observation is that there is still a large cash position in the market. In fact, according to The Bank Credit Analyst, cash as a percentage of the Wilshire 5000 (the broadest index of U.S. stocks) is at its highest level ever. It's a veritable mountain of cash.

If we've done our maths correctly and the Wilshire has a total market capitalisation of nearly US$9 trillion, that means there's about $8 trillion in cash, money market funds, and savings waiting to hit the road. Where will it go?

It doesn't look like investors are buying the "green shoots" line being peddled by Ben Bernanke. That means the cash may not be going anywhere. Or-again using the Faber thesis-it could go into U.S. bonds. Faber also says that on a price-to-book basis emerging market stocks look a lot more attractive than U.S. stocks.

We reckon U.S. investors are still scorched from the last two years and would be reluctant to get back into the market with authority via emerging market stocks. That alone might make emerging market stocks good value for money. It doesn't really tell us where all the cash might go, though, does it? We can think of a few places and will have more to say about it tomorrow. Until then!

Dan Denning
for The Daily Reckoning Australia

• Economy of China to Decelerate?
• A Mal-Adjusted Global Economy
• Wage Pressure in China to Drive Up Cost of Goods in Australia
• China Fueling Inflation in Australia & New Zealand
• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike

So what now? Well, the Chinalco bid came at the bottom of the market. Things are a bit better now. And shareholders seem eager to provide the needed capital rather than bringing on board a suitor whose intentions are at best, opaque.

It certainly takes Wayne Swan and the Foreign Investment Review Board off the hook. But the question of how Australia will manage future overtures from state-owned Chinese companies is still on the table, and will be for many years. China has capital and a large appetite for Aussie resources. That won't change any time soon.

But in the meantime, the market looks a little tired. The Dow managed to eke out a 77 point gain overnight. Aussie stocks, though, are in the red. The only real movers today are over in the commodity patch with oil and gold.

Dan Denning
for The Daily Reckoning Australia

• Wayne Swan Approves Chinalco Investment in Rio Tinto (ASX: RIO)
• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Were Chinalco’s Intentions With Rio Always Honourable?
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package
• Australia & China: Already Partners in the Commodity Boom

Mind you, this is if you want to be in the equity market at all. There is a very good case to be made for NOT being in the equity market this year, or only being in those asset classes and single stocks you think will appreciate (or grow earnings) faster than the rate of inflation.

But let's be more direct and say that this is still a bear market. The bear market began in 2000 with the popping of the tech bubble. The Fed fought back in 2003, setting a low-interest rate policy the rest of the dollar-pegged world followed. This kicked of leveraged booms in residential housing, credit derivatives, and stocks, bonds and commodities.

All those bubbles are popping. You do not wipe out twenty five years of credit and leverage excess in a mere eighteen months. We are barely halfway through the liquidation/loss realisation phase. The essential question is which assets are going to perform the best as governments inflate and create a new bubble in government debt? And by the way, it's going to be very large bubble.

Forget the $1.8 trillion deficit the Obama White House admitted to today. Forget the A$60-$70 billion deficit Wayne Swan is going to shove down your face tonight. The true scope of government borrowing is breathtaking, and rather sickening. More importantly, you have to wonder where the money is going to come from, and what will happen when it's not forthcoming from private investors.

Consider the chart below, courtesy of Niels Jensen, writing in John Mauldin's "Outside the Box" e-letter. Niels shows that according to IMF estimates, twelve governments around the world (the 'Dirty Dozen') will have to issue $10.2 trillion in bonds to cover future banking losses and funding requirements in the credit markets as a result of the ongoing financial crisis.

The 'Dirty Dozen' and $10.2 Trillion in New Bonds

Ten trillion is a huge number. But there's every chance the number is, in fact, a conservative estimate of government borrowing requirements. It is based on smaller than expected losses in the banking sector (the bogus scenarios modeled in the U.S. Treasury's 'stress tests') and a lower-than-average increase in public borrowing to deal with a financial crisis.

The IMF estimate is that public sector borrowing will grow to an average of 27% of GDP in Western or industrialised countries. But according to a study by economists Carmen Reinhart and Kenneth Rogoff published last year, governments almost always underestimate the amount of public borrowing that takes place in the wake of a banking crisis.

They do because-as the government here in Australia has done-they underestimate the blow to tax takings that comes from lower bank lending and lower economic growth. Tax takings fall while spending generally increases, especially borrowing to subsidise lending in key sectors like say, high-risk mortgage lending and property development. Think of the AOFM's role in buying securitised residential mortgage backed securities and Ruddbank.

So how big could government bond borrowing needs get? Under the 'best case' scenario (lower loan losses, quicker economic recovery) Rogoff and Reinhart say public sector debt would grow to an average of 40% of GDP, leading to global borrowing needs of $15 trillion-50% higher than the IMF's estimate. But that's just the best case scenario.

Using the chart below, Reinhart and Rogoff suggest that in previous banking crises, government borrowing as a percentage of GDP has risen to an average of 86%. Under that scenario, now you're talking $33 trillion in global government bond issuance in the coming five years to deal with the rest of the losses in the banking system.

The Mother of All Bubbles in Government Debt

You can see why we think all this talk of recovery and rally is a bunch of hokum. Maybe it won't be quite 86%. Or maybe it will be more. But we know for a fact that global governmetns are going to flood with world with bonds in the coming years. But will investors buy them? If they don't, you can expect much higher bond yields and much more money printing. That means inflation.

If you think this is just an American problem, think again. Professor Paul Kerin of the Melbourne Business School says Australia's government has already over-responded to the crisis with its policy response. Writing in yesterday's Australian, he says, "I estimate the 2008-09 and 2009-10 deficits announced tomorrow [tonight] will exceed $32 billion and $55 billion respectively, and that net debt will exceed $250 billion by mid-2013."

"In the past half-century, the cash deficit has never exceeded 4.1 per cent of GDP -- that was in 1993-94, when unemployment was running in double digits. Net debt has never exceeded 18.5 per cent of GDP -- that was in 1995-96, the sixth straight year of deficits run to fight high unemployment...Yet the 2009-10 deficit will exceed 4.5 per cent of GDP -- topping our 1993-94 record. And net debt will exceed 17.4 per cent of GDP by mid-2013, beating the 1995-96 record."

As you can see from the chart below, the government's deficit spending and borrowing ambitions have already steepened the Aussie yield curve. This makes long-term debt more expensive for ALL borrowers in Australia and will probably push up mortgage rates too, gagging the rebound in the housing bubble and jeopardising the one sector that's held up the economy through the early stages of this so-far mild recession.

Australia's Yield Curve Steepens

One last note on this before we move on to the investment strategy. A lot of readers ask how hyperinflation can happen in Australia if the U.S. dollar is weakening against the Aussie dollar. Further, you might wonder how the expanding American deficit has any bearing on the fiscal stability of the Australian economy. They are great questions.

There are four factors that we believe will lead to an even weaker fiscal position in Australia and lead to more borrowing and a weaker Aussie dollar-despite the circumstances that are undermining the U.S. dollar. Or to be plainer, U.S. dollar weakness is not going to be enough to keep Australia's currency sound.

So what are the four factors? First, government tax takings are going to fall more than expected. This is already the case. Lower commodity prices are going to compound the problem in the second half of the year. Barring a full recovery in the job market, the government is factoring in revenues that will not be there, while increasing spending.

But the big increase in Aussie government borrowing will come elsewhere. If indeed there is a "second half" to the capital crisis in American and European banks, it means financing needs for the Australian economy are going to have be backstopped by government guarantees or direct loans (Fed style, a la the TALF).

Sectors that the Australian government may have to borrow on behalf of or loan to include the commercial property market, the residential property market, and the corporate bond market. Right now the Australian Office of Financial Management reckons it won't have any trouble selling $1.4 billion per day to finance growing government deficits. But how much larger will Australia's borrowing needs become if the government must become the lender of last resort to all these other credit markets?

And if Aussie government-competing with all those other countries for global savings-can't sell its debt abroad-how do you think it will pay for it? The Reserve Bank will do what the Fed, the ECB, the Bank of Japan, and the Bank of England are doing. It will print money to buy government bonds. It will monetise the debt. Quantitative easing will begin in Australia and inflation will have arrived.

Does that seem impossible to you? Is it just Doom and Gloom pornography? We're certain a lot of people will find this scenario absolutely unbelievable. But in a worldwide credit depression where government borrowing needs amount to nearly one third of all global savings, you have to wonder how Australia is going to raise money against the likes of the U.K., Japan, and the U.S. If it can't do it, it'll have to print.

So back to the question. What does an investor do? Well it's worth noting that Microsoft appears to be preparing for massive inflation by borrowing. The company is selling $3.75 billion in debt in order to buy back some of its own shares. Obviously Microsoft reckons the real value of the debt will diminish with inflation while the current purchasing power of the borrowed money allows it to buy back its own shares.

It's a nifty trade and provides the example of buying equity in world-class businesses at cheap prices. There have to be a lot of investors in the world out there who see the end-game of this explosion in government debt and would much rather buy equity. That alone means the "weight of money" argument for equities could send shares higher.

We have to admit we are extremely dubious of this strategy because it says nothing about how these businesses will perform in a world saddled with so much debt. But we suppose if you are a truly a long-term investors and have decades to wait, buying equities at these lows is, a) a much better idea than buying government bonds, and b) about the only sensible investment strategy if you're going to stay in the equity markets.

Incidentally, Swarm Trader Gabriel Andre has been thinking along these lines himself lately. He's applied his Swarm system to the ASX/200, looking for entry and exit points on Australia's largest stocks. His aim is to find which Aussie blue chips present long-term buying opportunities and which are looking mighty over-bought.

Mind you, Gabriel is a technician. He doesn't look at fundamentals at all. Still, we've been reviewing the early results of testing the Swarm on blue chips for the purpose of issuing buy, sell, and hold recommendations. And we have to say, it's looking pretty intriguing.

But let's say you don't want to buy-and-hold blue chip stocks. And let's say you want to be in the market and not just in gold, vodka, bullets, and canned goods (although if you are preparing in that way, you should check this out). If you're a "financial survivalist" what else can you do?

Try uranium and lithium (as investments, not meals). In late November, we tipped an Aussie-listed uranium producer in Diggers and Drillers. The stock is up 90% since then. And this was a relatively "safe" stock because it's already producing from mines in Africa, with plans for a joint venture in the Northern Territories. It also owns some excellent ore bodies in Queensland, if the government there ever decides that it would like a uranium mining industry.

We reckon the government WILL decide that because energy is an industry that's going to survive the credit crisis. In a recent Diggers and Drillers weekly update, we reported that China is building twenty one-gigawatt nuclear reactors at the moment. China will not be able to supply its own uranium needs. Australia, with over 30% of the worlds proven uranium reserves, is in position to capitalise, should it so choose.

According to Scotia Capital Inc. China strategist Na Liu, China's nuclear industry will consume 15,700 tonnes of uranium per year by 2020. "At this rate," she writes, "China's currently known uranium resources can only last for five to 10 years. Clearly, in our opinion, it is imperative for China to secure long-term supply through imports or investment."

That "other investment" is why we've drilled down further into the roster of junior explorers in the coming issue of D&D. The explorers and prospect generators are starting to look interesting. We're also going to have another look at lithium.

Back in May of 2008 we profiled the rare earths industry, including Australia's two best rare earth stocks (both of which became recommendations, both of which got slaughtered in the market correction, and both of which have doubled from the lows after partnering up with Chinese investors).

In that report prepared for subscribers, we also looked at lithium. Enhanced battery life and power is becoming a key issue for a world filled with mobile telecommunications devices. It's also critical for hybrid-electric cars that can store an electric charge. One of the stocks we profiled in that report has just signed a letter of intent to build a lithium carbonate processing plant...in China.

So you see, for the resource speculator, an inflationary boom can be the best of times. It is a high-risk exercise. But junior resource stocks are one of the asset classes the CAN go up faster than the rate of inflation. And if, as we believe, the explosion in government bond issuance is going to lead to an inflationary rally in stocks, then dabbling the junior resource stocks and small caps is like hitching a front seat on a rocket.

Remember, this is pure speculation. You only hope your rocket is like Richard Branson's new Virgin Galactic space plane, and note the nuclear missile Slim Pickens rides in Dr. Strangelove.

And what about red wine? The bottle shop across the street from the Old Hat Factory is closed for renovations. In its clearance sale, we were able to pick up a few bargain bottles of Penfolds Bin 389 Cabernet Shiraz. That is wealth you can either drink or store. We've done a little of both.

But you can also sell it! There appears to be a roaring trade in Penfolds wines on e-Bay. There are certainly worse things you could spend depreciating paper money on. We're also hearing that the 2004 vintage of the Penfolds Grange is the best ever. Can't wait to find out.

Dan Denning
for The Daily Reckoning Australia

• Government Debt Bubble is What Directly Precedes Inflation
• Uranium: A Carbon-friendly Substitute for Coal
• A National Mortgage Bubble
• The Economic Illiterati
• Debt and Deficits Do Matter

For now, at least for this week, it sure does look like the appetite for risk is back. The U.S. dollar and Japanese Yen are weak, while commodity currencies like the Australian, New Zealand, and Canadian dollars are up. Bond prices are down, stocks are trending up, and even oil is creeping back over $50, looking to make a breakout. All of this confirms that we may have a "second wave rebound" from the March lows.

We have grave doubts about the durability of this rebound, given the state of the economy (unemployment, debt, and rising deficits). However we're not going to bother with any of that today. If you traded the rebound for profits, good on ya! We are using this moment of relative tranquillity to ponder what's just around the corner.

One object bearing down on the Aussie economy is a 'temporary' deficit that may last until 2016. Liberals, Labor, Republicans, Democrats...they all know how to spend money they don't have. All political parties appear to support big government these days. It's so trendy.

But you wonder if the Australian is starting to worry that the current government is writing checks the future will have to cash. Today's Australian Financial Review reports that next year's Federal budget deficit will be at least $70 billion. It says that Treasurer Wayne Swan has told his state counterparts that, "tax collections would fall by $200 billion over four years, worse than a $115 billion write-down in February."

"There is no doubt that the deficit will last longer, the temporary deficit will be longer, as a consequence of the revenue downgrades imposed on this country by the rest of the world," the Treasurer said. The AFR says the government plans to return the budget to surplus...by 2016.

Here's a stupid question: is something really temporary if it lasts for seven years?

However long it lasts and however big it gets, the deficit (and growing debt) mean Australia will be borrowing more to support its current lifestyle. This is an alarming trend. Temporary government spending and revenue programs almost always become permanent. And that's what would worry us about this deficit: it's the beginning of Australia's long road to debtor status.

But hey! Judging from the hate mail in the mail bag, people are tired of hearing about the long-term consequences of making promises you can't keep. It is not fun to think about the transfer of national income that occurs when you rack up debts to bond holders. And it's not fun to think about what happens when the government is unable to fulfil the promises it's made. So let's not think about that, shall we not?

Instead, let's go straight to the mail bag. Lots of good stuff. And finally, some contempt!

--Hi team,

Your comment "Copper rises on Chinese buy prospects" is interesting except that Chinese are buying copper ASSETS and will no doubt dictate the future price they pay from their owned Australian producers (refer Oz minerals buyout and others).

JHM

--Actually, we were quoting a headline from an article in The Australian, but your point is well taken. China is doing both. It's stockpiling raw commodities. And it's buying shares in publicly listed commodity producers. However, there's a big difference between a customer of an Aussie resource producer buying the producer, and another producer buying the producer. If the customer is buying the producer (iron ore), then it's conceivable the Aussie firm will be run not to maximise shareholder value but to give the consumer (who owns a sizeable chunk of equity) bargain basement prices. When a producer buys a producer, the interests of the two parties (getting the highest price of the commodity produced) seem more aligned.

--Dear DR,

I'm still curious as to how can we have hyperinflation and a property market crash at the same time. While I understand the logic, I still can't wrap my head around how the also heralded hyperinflation will come into this. Please end my suffering by addressing this in your next issue as this enigma just keeps me wondering.

Kind regards,

Susanna

--Ah. Two good questions. A real hyperinflation destroys wealth and puts a premium on real goods that are tradable (liquid). A house is not tradeable. So while the value of mortgage might quickly be inflated away in the early stages of a hyperinflationary scenario, we would not recommend it as a way to get rich. With prices so surreal, the value of large assets in hyperinflation becomes volatile. We'd suggest this makes for an illiquid market, and doesn't help you at all with respect to day-to-day economic activity (where you can barter liquid tangible goods for other goods or services). Try bargaining your rumpus room.

On the other hand, at least you have a roof over your head. It's a subject we need to more research into. But to be as clear as possible, we don't believe buying a house is a real hedge against hyperinflation. Not much is.

The other question you had is how it all begins, this hyperinflation. We would argue that the expansion of the global monetary base has been so large that it's going to be nearly impossible to reverse. So far, the huge expansion by the Fed and other central banks has not made its way into the real economy. Its being held as "excess reserves" at those central banks rather than loaned out into the economy where the multiplier effect would quickly lead to inflation.

The Fed thinks it can soak up these excess reserves before the banks loan them out. After all, the banks would only do so once they thought the economy was safe enough to lend into again, as my colleague Gary North points out. The Fed can try and prevent this increase in the money supply by raising reserve requirements (effectively forcing the banks to keep the cash parked). But if it does so, it risks derailing the so-called recovery. The whole point of the Fed's balance sheet expansion was to create a recovery anyway.

The Fed is hoping that it can reduce bank reserves before they hit the economy. It thinks that the demand for its short-term lending programs will go away as the economy recovers. It also says it can conduct "reverse repurchase agreements." This essentially means the Fed will be SHRINKING the money supply as the economy recovers.

Our guess? The Fed is going to have a devil of a time preventing excess bank reserves from departing the monetary base into the money supply and the real economy. New bank lending and higher interest rates will fuel even higher prices. And down the rabbit hole we go.

--Dan,

There has been a lot said about the problems easy credit has caused. But what is the solution to easy credit? How do you suggest credit is made harder to get? Is there any other ways than just lifting interest rates?

Glenn D

--Taking the power to dictate the price of money away from a cartel of bankers would be a good start. There is a market price for money, or a natural rate of interest required by lenders to make surplus capital available to borrowers. This natural interest rate is what Central Banking is designed to distort.

The government prefers a monopoly on money because two institutions stand to benefit the most from "just a little inflation;" the government and the banking sector. A free market for money would mean that the supply of credit would probably not exceed available savings. At the very least, the collateral required to secure a loan would be more substantial that it has been for the last twenty years.

Is there a cure, then, for credit excesses? The Austrian economists say no. The only cure is prevention. One the disease has been unleashed, you can only deal with the misallocated capital and try to liquidate the losses and begin again. Ludwig Von Mises argued that the government control of the interest rate is what sets off the boom/bust cycle to begin with. With a market rate of interest, these booms and busts would be moderated. But that would destroy the illusion that central banks can carefully manage an economy (price stability and full employment) by manipulating interest rates.

This was the subject line of an e-mail this week: "Stupid remarks from DR"

For example: "This represents a $50 billion deficit. Compare that to last year's $22 billion surplus. Not a good look for K-Rudd's CV."

What a truly mindless buffoon you appear to be.

Doubtless you also supported your erstwhile heroes who sat on an unprecedented minerals boom, passing the surplus out to their mates instead of investing the surplus in Australia's future.

Do you really believe that Rudd caused our current problems? Really? Maybe his solutions will prove inadequate or wrong but unlike you and your cronies he is doing something. And what suggestions have you got to get us out of the problems caused by your like thinking mates??

None, except the greed based "look after yourself and to hell with everyone else".

As I am sure even you have realised by now I am less than impressed by your vacuous political drivel.

Leave comments to those who are at least prepared to try and do something about the situation and stop the cowardly firing at their backs.

Contemptuously yours,

Alex Millar

--We don't support politicians in anything, ever. If more of us looked after ourselves and our neighbour and families instead of looking to government to "do something" the world would be a lot better off. Does this mean you'd like to unsubscribe?

--Dear Sir,

Your newsletter is really up with the best. My question is since most governments are going broke and most banks are broke where is all the money coming from? The Australian banks have $7-$14 trillion of toxic debt, the world supposed to have over $1000 trillion, ten times more than all the GDP of all the world. If this is the case, where is the money coming from? Who or what is holding up the economies of the world? If the money is just being printed which I believe it is there is no way out but a TOTAL collapse.

If you can answer me it would be really appreciated.

Thanks,

Rafael C.

--We're not sure about your toxic debt figures. But you ask a good question. Asset values-as we've found out in the last year-are largely bogus. They are deflating. As for what's holding up the economies of the world? Well, there are real industries and demand for real goods. But if you mean all this deficit spending and bail out money, that either is borrowed (mostly from Japan, China, institutions, and private investors) or its printed out of thin air by central banks.

--Hi,

Thanks for your constantly interesting pieces. My question is - why should we really believe gold has any value? For most of the last 5,000 years, animals were the key mode of long distance transport - they no longer are. Why will gold not go the way of the horse and cart?

I understand the reasons behind why you think the gold price will rise. However I think there is a flaw in your logic. You say that "But just remember, this whole experiment with fiat money is not even one hundred years old. Just because it's all we're used to doesn't negate that for 5,000 years of human history, people have been using gold as money". This always seems to be the argument for gold. The fact that it has always been used as a currency, therefore it is what will keep its value.

For gold to store value, don't people need to agree that gold is valuable? I have never understood why people put a value on gold. I agree it looks nice and is useful in jewellery and fillings, and I think it's also a reasonable conductor of electricity - but that's it.

If tomorrow, someone succeeds at alchemy, or the world just decides that gold isn't it anymore, it will be absolutely worthless - and it will go down the path of the Zimbabwean $. Wouldn't we be much better off storing some real, useful commodities (copper, tin, tarmac, soy, hogs, OJ - of course limited to the practical problem of actually storing these things). It seems to me that to believe gold will increase in price, requires other people to believe it will increase in price and has a real value/use - whereas actually it doesn't.

Thanks,

Samant

--Gold has four physical properties that have made it extremely useful as a medium of exchange over time. It is durable. It's divisible. It's convenient. And it's consistent. That doesn't mean other things haven't or can't be used as a medium of exchange. It just means these physical attributes of gold make it especially useful. That's not a matter of mystical belief. It's a practical benefit.

The fact that you can't "succeed" at alchemy is also what makes gold desirable as a medium of exchange: it's supply is relatively stable because it cannot be counterfeited by governments. The usefulness of any medium of exchange would decline if a person or a small group of people could easily increase the supply. It would make the unit less stable. Gold supply varies with mine production and above ground sales from central banks. But you can't just drop it from helicopters like brand new paper money. Well, you could, but it might hurt.

Does that mean it has intrinsic value? Well, if by intrinsic you mean that its unique physical properties make it useful as a medium of exchange, then yes. But value is only ever determined in an exchange. Gold is useful only as long as people believe it to be a useful medium of exchange. We think more people will realise that in the coming years.

--Dan

Are you an optimist, a pessimist or an economist?

Larry

--We're Catholic.

And one last note on property.

If we are already "smack in the middle of the biggest economic collapse in 80 years", this economic collapse is not that bad after all! In the worst case scenario; today's people living in the industrialized countries are unlikely to go begging for foods, unlikely to go through winter without enough clothing.

This financial collapse is largely on paper (or computer screen); the transfer of assert ownership from someone to someone else.

The world's factories are still standing, infrastructure are still there to facilitate economic activities. Demand is still there, the population in China is a few times that of the United States; with ever improving production technologies, they will not allow their living standard to be substandard for long.

Wherewithal is still there, if someone owe [sic] someone else three trillion dollars, that someone else must be rich, has plenty of money to spend and invest!

Even confidence is still there; for sure the share market will go down after ups, but the surge in the last two weeks indicated refreshingly, more investor [sic] than not don't share the dim view of the Daily Reckoning.

For those unfortunate home owners being foreclosed, many may not be eligible for a home loan in the first place.

I think you are wrong.

David Tam

--We'll drink what you're drinking. But fair enough. If we've learned one thing in the last year, it's that we can be just as wrong as the next guy. That's why we reckon it up every day. Keep thinking!

Dan Denning
for The Daily Reckoning Australia

• World Economy Faces Hyperinflation or Deflation?
• Brazil is a Good Place to Become Rich
• June Producer Price Index Indicates Slower Inflation in Australia
• Now is the Time to Find Out About Gold as Money
• We Don’t Serve Hamburgers

Oh wait. We forgot about the 'stress tests.' Remember that's the official government report of how the 19 largest U.S. banks would hold up under further loan losses or asset write downs. It's designed to give investor (and the banks) a transparent picture of how much capital the banks need to be unequivocally healthy.

Actually, it's not designed to do that at all. The 'stress tests' are a white-wash. There's no way the government would release a report to the market that said the banks were in horrible shape (insolvent) and needed billions more in capital to make up for billions of losses in residential and commercial real estate.

That means either the 'stress tests' were a bogus exercise in deception. Or, to the extent they uncovered anything legitimate, it will be leaked in the press and priced into the relevant banks shares before the tests ever hit the public. Besides, the 'stress test' began in 2007. The market's already told us what it thinks of the banks.

One more quick note on commercial real estate. Is it still 'the other shoe to drop' on the banks this year? Maybe it already dropped! The Guardian reports that, "Global sales of investment grade real estate plunged 73% to $47 million in the first quarter from a year ago, or just one-sixth of the level two years ago, according to real estate research firm Real Capital Analytics on Friday."

A 73% cliff dive is as good as a crash in our book. But that figure only refers to new sales. There is a lot of existing debt that has to be refinanced. "Making things worse," the Guardian adds, "the number of properties that need to refinance or need capital infusions is soaring. New reports of defaulted mortgages and failed commercial property companies surpassed $55 billion in the first quarter, bringing the total known distressed commercial properties to $153 billion."

This is one reason to remain suspicious of property and financial stocks this year. In fact, you can pretty much bank on the idea that these stocks will never lead the market again in the way did over the last five years. The sector that leads the market up in a credit boom never really fully recovers as the best-performing sector (think tech stocks).

One thing to watch for? The financial sector and state governments using the Federal wholesaled funding guarantee to trash the country's international credit rating. Macquarie Group used the Fed guarantee to raise $14 billion on international debt markets at the end of the financial year. The company has already set aside $200 million to pay the Feds for the use of the guarantee this year (think about that for a second, this government is 'selling' its credit rating for $200 million).

Macquarie is raising capital this way, "Mainly because Macquarie could actually save money on its deals because it did not have to rely on its lower (and therefore higher risk-rated) single "A" credit rating. Analysts have estimated Macquarie's benefit at $580 million for every $10 billion of new debt raised," reports Danny John in today's Age.

To be fair, Macquarie is also raising money from equity investors too. After announcing write downs that slashed its full year-profit in half, the company told the ASX it had sold $540 million in new equity to institutions. So here's the question...what is the bank loading up for?

By 'loading up' we mean that it's essentially re-arming itself to get back in the market...and do what? "Macquarie is already aiming to build a global stock-broking business centred on Asia, London and New York and to become significantly bigger in energy trading, specifically in oil and gas. It plans to buy new businesses and increase its existing operations with capital injections on the other side of its balance sheet."

Hmm, oil, energy, and Asia? That sounds like a strategy based on decoupling. Remember that? It was the idea that the credit crisis would hurt the U.S. and Europe but not so much the emerging market countries. But it depends on what you mean by 'hurt.'

Equity investors everywhere were 'hurt' in the last 18 months. Nowhere was safe. Nothing was decoupled. So now the question is which economies will recover first: the high-saving emerging markets with growing populations and rising incomes, or the highly-indebted industrial economies that are going even deeper into debt to bail out financial institutions (this is not a trick question.)

By the way, Western governments have been so fixated bailing out their banks they haven't noticed how Chinese banks and companies are providing critical capital to world-class mining projects. China picked up another valuable pebble when China Non-Ferrous Metal Mining Company picked up a controlling stake in the world's largest non-Chinese rare-earths producer for the paltry stake of $505 million on Friday. We'll have more on the sad strategic case of Lynas Corporation tomorrow and whether there is good news buried in the story of Aussie resource investors.

Is it fair to blame the government for leaving strategic assets hung out to dry? That's debatable, and the Treasurer still has to sign off on this deal. But obviously the government has other problems on its mind. On Friday, Treasurer Wayne Swan said government 'revenues' would be about $100 billion less than he expected with last May's budget.

What does all this lead to? We reckon the combined burden of Federal, State, and government-guaranteed bank borrowing is going to put a lot of pressure on the Aussie dollar and lead to higher interest rates. State governments are already under pressure. "Victoria may lose its prized triple-A credit rating as the State Government pushes the state deep into debt to fund new roads, railway lines, hospitals, schools and water projects, one of the big four banks has warned," today's Age reports.

The Wall Street Journal (and international investors) are on to the story too. The Journal reports that, "Australia's major states are all expected to post in the next six weeks a significant deterioration in their fiscal positions, strengthening expectations of a surge in state government bond issuance. A dramatic erosion in traditional revenues from land taxes and mining royalties will be a common theme for all states."

Dan Denning
for The Daily Reckoning Australia

• Economy Free to Recover?
• Bank Stress Test Not Stressful Enough
• Is the Macquarie Model Dead?
• House Prices Down and Aussie Market Enters Second Wave of Rebound Rally
• Australia to Borrow as Much as $300 billion

In the "no" corner, weighing in with some theatrically negative comments, is IMF managing director Dominique Strauss-Kahn. He told reporters yesterday that, "2009 will almost certainly be an awful year - we expect global growth to enter deeply negative territory. This is a truly global crisis, and nobody is escaping."

Nobody Wayne Swan. Did you hear that? Nobody! That means YOU!

Before we get to Australia's capital crisis and its Chinese future, just a quick note to say we won't be taking up the question we left you with at the end of yesterday's Daily Reckoning. It's the "what should we do" part of a world where the fiat money system cracks up, leading to a hyperinflationary/deflationary depression.

It's an important question-probably the most important you can ask these days. So we're going to collect and write up our thoughts over the weekend. Stay tuned! And if you want to send us your plan, don't be shy. dr@dailyreckoning.com.au

Meanwhile, what about the present? The IMF issues its World Economic Outlook twice a year. When times are good, the forecasts are too optimistic. When times are bad, the forecasts tend to be too pessimistic. And when times are really bad??

There is a problem for Australia buried in the IMF's comments we want to explore today. The problem is capital. Where is it going to come from over the next five years? Will Australia have a capital crisis?

The report says that one big consequence of the GFC is declining capital flows to emerging markets. With banks not lending at home in Europe and America, they certainly aren't lending abroad. The IMF said the decline in these capital flows, "may be protracted, given the solvency problems facing advanced economy banks that provide significant financing to emerging economies."

You could argue that Australia is not an emerging economy but an advanced, developed economy with two (and perhaps only two) world class industries (finance and resources). But what you cannot argue is that Australia is a net importer of capital and has been so for two hundred years. We didn't make that up. It's what the Australian Office of Financial Management told investors in a slide show in Dubai late last month (see slide 14). The AOFM hit the road-an investment road show-to entice investors to buy Aussie bonds. More on that in a second.

But first a question: would a prolonged credit depression choke of the capital imports that are the lifeblood of Australia's modern economy? After all, the Aussie housing boom was financed with a great deal of money borrowed from abroad. And the resource boom continues to depend on foreign capital (especially China) to expand. So is there a risk that Australia will experience a capital shortage in the coming years if the GFC drags out as the IMF expects?

We may surprise you and say the answer is "no." It's a qualified "no," though. First off, the banks are the largest importers of capital. If they have trouble importing capital, it's going to affect the Australian property market, both residential and commercial. But the government has already promised to fill this gap in two ways.

First, the AOFM was told by the Treasurer late last year to begin buying Residential Mortgage Backed Securities (RMBS) from non-bank lenders. It's been doing just that. And one interesting question is how much of the nearly $4 billion in RMBs the AOFM has already bought represent new loans made by non-bank lenders to First Home Buyers taking advantage of the big government grant.

If that doesn't sound like Fannie and Freddie buying subprime loans originated by Countrywide, we don't know what does. And we suspect that if the government wants to keep the housing market propped up, it will have to extend the first home buyer's grant past June 30th AND increase the role of the AOFM in buying securitised mortgages. After all, who else is going to buy them?

But while the government essentially underwrites residential property values via the AOFM, you can expect it to get busier providing capital to the commercial property sector too, via Ruddbank. You may have noticed that General Growth Properties, the second largest mall owner in America, filed for bankruptcy overnight. But even if you didn't notice it, we think this means the other shoe to drop in the second half of this year is major trouble in the Australian commercial property market. Why?

The Australian consumer is not much better off (by some measures he's worse off) than his American counterpart. Australians are growing their credit card balances, but paying off less and less each month, according to data published this week by the Reserve Bank. Credit card debt grew by 1.7% to $45.4 billion. But Aussies cut their repayments on that debt by 7.1%.

You'd have to expect major reverberations in the commercial property sector later this year if the Aussie consumer reaches his limit or loses his job. We expect that will lead to increased government borrowing and lending to prop the sector up in the same way it's propping the housing market up. It won't be cheap, either.

Ahmed Fahour is the man designated to run the Australian Business and Investment Partnership (ABIP aka Ruddbank). He is already expanding the mission of the bank beyond the backstopping of commercial real estate. He told the Australian Financial Review earlier this week that, "Right now, we're focusing on commercial real estate, but it does have the potential with all five shareholders to go beyond commercial real estate" (the five shareholders are the Big Four banks and the government).

Fahour has said the Ruddbank is a "backup plan" and not a bailout. But if things go to form in Australia-if capital remains scarce and the global economy continues to contract-Ruddbank will be a conduit between government money borrowed in the global bond market and Australian businesses that can't get capital any other way.

So how much is all this going to cost? A lot more than anyone expects, that's for sure. In its road show in Dubai last month, the AOFM produced a few slides that showed that Australia's net debt and debt-to-GDP ratios are quite favourable to other countries. And then it showed the chart below which projects the government's borrowing needs over the next few years. Have a look.

Australia to borrow over $40 billion each of the next three years

Click to enlarge

Source: Australian Office of Financial Management

So the Rudd government, through the AOFM, is hitting the road to hawk Australian government debt in order to pay for...well...for a lot of things. For the stimulus. For infrastructure. And, we reckon, for the funds to keep commercial property developers from going up and residential home prices from falling.

Of course there's no sin in being a net importer of capital. It means foreign investors are attracted to the rate of return on Aussie investments. But this is a trend that should worry any Australian who's had a chance to see what America has done to itself. It makes the country's economic growth dependent on foreign creditors.

A society that thinks it owes itself cash payouts and all sorts of other projects it can't pay for will happily borrow from the future to pay for the present. This is not so good for the future, though. What starts out as a temporary dip into debt to ride out a recession becomes a chronic habit of living above your means with borrowed money. Politicians support it because it's a way to keep the promises flowing without having to find ways to pay for them with current revenues.

The question we began with, however, is will foreign creditors like the Chinese and Japanese or the Petrol States simply cut Australia off and invest their money elsewhere (or in their own economies)? Right now the Federal Government enjoys a triple A credit rating from Standard and Poor's. But if the Federal government steps in to guarantee the borrowings of State governments (the same way it's guaranteed the borrowing of the big four) then the credit rating might not be so gold plated.

This means rising borrowing costs for the AOFM. This means the habit of paying for your projects with money borrowed from the future gets even more expensive (even if you call it 'investment' rather than say, 'plundering from the future'). This also means your taxes are probably going up (GST).

But it does not mean China will not be interested in Australian resources. And this brings us to the "yes" part of the question we set out to answer at the beginning of today's journey. Australia can mitigate the effects of severe recession, perhaps, by opening its arms wide to embrace its Chinese investors. Very wide.

Even though it was at a ten-year low, Chinese GDP grew by 6.1%, according to data released yesterday. That's good news. But as Michael Pascoe writes in today's Age, the better news is that the GFC is accelerating China's exit from its huge U.S. dollar reserves...and into tangible assets.

Pascoe points out that the commodities bubble has definitely popped, but that the boom is still on trend. Base metals and bulk commodity prices are lower than they were in 2008...but a lot higher than 2006 and mid-2007. He says prices have reverted to the rising trend, not crashed.

He also quotes Nobu Su, the head of a Taiwanese commodity firm, "China has woken up," Nobu says. "The West is a black hole with all this money being printed. The Chinese are buying raw materials because it is a much better way to use their $1.9 trillion of reserves. They get ten times the impact and can cover their infrastructure for 50 years. The next industrial revolution is going to be led by hybrid cars, and that needs copper. You can see the subtle way that China is moving into 30 or 40 countries with resources."

We hope Nobu is right. Over at the Australian Small Cap Investigator, Kris Sayce has tipped two Aussie rare-earth metal companies that could benefit from a boom in hybrid cars. That would be welcome news indeed.

But the larger argument and question is if Australia will ride out the GFC on China's foreign investment coat tails. Even that is no sure thing. It's one thing to sell Aussie resource firms to Chinese partners. But how will that halt rising unemployment? How will it save the retail economy? What will it do for house prices and commercial real estate?

Despite the "glimmers of hope" and "signs of stability" alluded to by talking heads and politicians, we see nothing of the sort. This kind of talk is just self delusion. It wouldn't surprise us at all if the people saying these things are in the meantime burying gold in the backyard and hoarding bottled water in the spare bedroom. More on survival strategies for the rest of the year next week!

Dan Denning
for The Daily Reckoning Australia

• Australia to Borrow as Much as $300 billion
• The Dark Underbelly of Australia’s Resource Boom: Chinese Resource Demand
• Australia Ponders its Chinese Future
• Aussie Banks Addicted to Foreign Borrowing
• IMF Report Concludes Aussie Banks are “Very Sound”…

Wait, did we just say that? Sorry. What we meant is, ahem, "More stimulus, please Sir."

Yesterday's retail sales figures from the Australian Bureau of Statistics show that the short sales high enjoyed by retailers in December all but vanished by the end of the February. So the government, according to today's Australian, is already preparing another stimulus to get people back in the shops. Meanwhile, in the wider world, storm clouds are forming in commercial real estate and the corporate bond market. More on that in a moment.

The seasonally adjusted retail sales figures showed a 2% fall in sales in February. That followed January's meagre 0.5% gain and December's $8.7 billion stimulus-inspired 3.8% gain. It really is amazing what you can do with statistics though.

The non-seasonally adjusted figures actually show a 12.9% month-over-month fall in sales. And according to the ABS, sales at chain retailers and large stores fell by 16.3% in original terms. Yet the seasonally adjusted numbers show a fall of 9.8% for large retailers in February, after an 8.3% rise in December and 0.5% fall in January.

So what gives, why is there a huge difference between the seasonally adjusted figures and the original data series? If you look just at the original data series you'll see that retail turnover has declined 32.1% in original terms from $24.7 billion in December of 2008 to $16.6 billion in February of 2009.That would be headline news! But the headlines show just a 2% month-over-month fall. Still news. But not earth-shattering.

To calm our troubled mind we called the ABS and found them to very helpful in clarifying the methodology of the Retail Trade Survey. The conversation was edifying. We learned that ABS phones up around 2,700 respondents each month to get a total turnover figure. It surveys large businesses and small ones, cafes and big box retailers, companies that do over $50 million in monthly turnover and those that do considerably less.

Those numbers are then seasonally adjusted using a number of "forward factors," which frankly, we couldn't understand. But the main goal of the adjustment, our friend at the ABS explained, is to smooth out the variability in the series to give a picture of the overall trend.

"However we've had to suspend the trend estimates for the series starting in November of last year," he said.

"Why is that?"

"Well the stimulus measures are basically forcing everything way up."

"So it's distorting the figures?"

"Yes."

"And actually making it harder for you to tell what's going on at the retail level."

"Yes, for now."

If you zoom back out from this level of statistical detail, what do you find? Well, the stimulus got people busy for a few months and they spent. Some of them may have saved the initial cash splash in December, only to spend it February. Judging by the number of large empty TV boxes awaiting trash pick-up over the last few weeks, Australians don't seem all that concerned about the global economy.

But will the Reserve Bank be concerned enough about the dodgy retail sales figures to cut rates on Tuesday? And if so, by how much?

Questions and questions. Always with more questions. Our main point is that the stimulus has produced a great deal of sound and fury, but it doesn't signify that Australians are any wealthier or more financially secure than they were a few months ago. The money wasn't invested in capital assets. It isn't producing anything.

Confirming the same mistakes of the last twenty years, it was more money spent on consumption. That's just retail therapy via government handout. It hasn't improved the nation's economic health or its prospects. Maybe the Prime Minister ought to just shout the country a beer on the weekend. It would have the same effect. And more people would benefit!

How about prediction then? The OECD is now predicting that its member nations will see their economies shrink by 4.3% this year. This is what Treasurer Wayne Swan and acting PM Julia Gillard call "negative growth." What's more, OECD reckons that unemployment rates in industrialised countries will hit double digits. Note to OECD: it's already there, but government statistics are concealing it.

What are we on about? Well, today we woke up with the feeling that a second more vicious bound of deleveraging and "negative growth" in the economy is just over the horizon. Shrinking international trade...rising unemployment...and now...according to Moody's, which just downgraded US$1.76 trillion in corporate bonds...rising defaults on corporate debt and big problems in commercial real estate.

All of these things could conspire to send the Aussie share market to new lows. We're in a period of calm where the crash-and any time shares fall 50% it's a crash-has stalled. Stocks have rallied 20% world-wide. Oil is weak. Gold is idle. But is this the long and bumpy bottom?

As the chart from Doug Short below shows, the S&P 500 is down 48.9% from its all-time high. It was down as much as 56.8% before this recent rally. And at its current level, the 48.9% matches the 48.2% fall in the index during the 1973 oil crash and the 49.1% fall in the tech wreck (which drove the NASDAQ down even lower.

Click to enlarge

Source: http://dshort.com/charts/bears/four-bears-large.gif

Obviously the scary scenario is that this twenty percent rebound has no real conviction. It is still a smaller rebound in percentage terms than the rebound in the Dow after the '29 crash. That rebound led the Dow up nearly 50% in eight months before economic reality set in. From that point, it was long dark march to a nearly 90% decline from the highs.

So we are at moment of truth of sorts. Either this Great Depression rhetoric is hyperbole designed to sell newsletters and newspapers or it is real. If it is rhetoric (or just an inaccurate forecast, if you prefer), stocks will rock back and forth gently higher over the coming months. This implies a recovery in trade and the economy sometime late this year or early next.

If, however, it is real, then this rally is going to collapse and stocks are going to head much lower over the next two years-and maybe many more. If this were the case, then a major revision of your asset allocation would be in order, one that factored in falling share prices over the next five years.

What would that asset allocation look like? Would gold and oil hold up if assets deflate at the rate we're discussing? More on that tomorrow.

For now, let's be clear that if a second wave of bank write offs and loan losses from corporate bonds and commercial real estate hits, no one knows how the banks will fare. Presumably, current stress tests factor in even larger loan losses (you'd hope). But at the very least it means U.S. and European banks will need more capital. Where will they get it?

Well, they'd like to get it from China, Japan, and the Gulf States (those countries with the largest foreign exchange reserves. Maybe they'll get it. Or maybe Australian mining firms will get it. Which brings us to what this means for Australian resource and financial firms.

If the second wave of the global financial crisis is imminent, capital is going to become an incredibly scarce commodity. Some will flee to the U.S. Treasury market. Some to gold. And some to mattresses. How much will flee to Australia?

"Australia just does not have the capital to be able develop its own assets," says OZ Minerals CEO Andrew Michelmore. His company appears to have gotten out of jail by selling its second-tier mining assets to China and holding on the Prominent Hill gold and copper mine in South Australia.

"Companies in Australia in the resources industry have forever relied on foreign investment to be able to develop," he added. The question this year is how much capital Australia is going to have to import to keep businesses and households functioning normally. Of course, it's not a normal time, which means Australia could become capital starved much sooner than anyone currently expects.

Dan Denning
for The Daily Reckoning Australia

• How Much Worse Can the Stock Market Get? A Lot Worse
• Japan: A Morality Tale of Banks and Government Refusing to Deal With Debt?
• Financial World Has Every Reason to Encourage Government Stimulus
• Economists Agreed the Stimulus Was Working and the Recession Was Coming to an End
• Who Can Blame Consumers for Being More Ready to Spend Money?

The Treasurer said that Prominent Hill-OZ's major copper and gold asset in South Australia-is too close to the Department of Defence's Woomera Testing Facility. It's about 160km away. Swan said, "The Woomera Prohibited Area weapons testing range makes a unique and sensitive contribution to Australia's national defence," and that, "It is not unusual for governments to restrict access to sensitive areas on national security grounds."

That means you China. Stay away, sort of. That is, Swan did not rule out an alternative bid for OZ that does not, presumably include Prominent Hill.

This is no laughing matter for OZ or its shareholders. The company has $1.3 billion in debt it must refinance by Tuesday. The $2.6 billion bid from Minmetals would have solved that problem. But now the question is whether OZ's bankers will give it more time, or pull the plug.

Part of this problem is of the company's own creation. As of August last year, it classified the $1.3 billion in debt as a "non-current liability," assuming, we presume, that it would be able to refinance that debt easily enough. That was obviously not the case. And now the clock is ticking.

But would the Treasurer make a decision on Friday night that would put the company in receivership by Tuesday? Is the government convinced that OZ is being run by the gang that couldn't shoot straight and is better off being cut up into parts and sold rather than delivered into Chinese hands whole?

Maybe we'll never know what the Treasurer is thinking. But it may not matter. The Australian Financial Review reports this morning that Minmetals revised its offer over the weekend. The offer excludes Prominent Hill but includes the Sepon gold mine in Laos and the high-cost but massive Century zinc mine in Queensland. More on this story tomorrow. OZ is currently in a trading halt.

The big G-20 meeting gets going later this week. Stocks in New York were down Friday but have enjoyed a pretty good month so far. Here in Australia, stocks are up 16.75% since the ASX/200 closed at 3,145 on March 6th. Does this rally have legs?

If the market is channeling the market from the Great Depression, then yes, the rally could last months and recoup as much as 50% of the losses since it peaked at 6,828 in November of 2007. It's hard to say what kind of economic news might come down the pipe to cheer investors that much.

Investors are currently a pretty gloomy bunch. But perhaps the aggressive monetisation of debt by the Fed will drive institutions out of bonds and into stocks. There is a lot of cash in money market funds that could get back into the market and send stocks up quickly.

Or perhaps not to all of that. The Economist Intelligence Unit has just released a report that predicts a 40% chance of global depression. The report is called "Manning the Barricades: Who's at risk as deepening economic distress foments social unrest."

To be fair, it also says there is a 60% chance the various stimulus efforts in the developing world successfully stabilise the global economy and share markets. But it says there's a 30% chance of global depression and a 10% chance of global depression with massive social upheaval.

Magazine cover contrarians know that any time a big claim is safe enough to put on the cover of a mainstream publication, the trend behind it is probably over. If this is the case, the Economist article is a massive buy signal. But it's also possible the Economist has gone as far as it can without terrifying its readers and more importantly, its advertisers.

In other words, it's possible that things are a lot worse than the Economist is willing to say, which is not exactly a comforting thought. More on this tomorrow as well.

Amidst all these dire forecasts comes another prediction of higher oil prices. In a Wall Street Journal article on Friday, Richard Jones, the deputy director of the International Energy Agency, said the oil crash of 2008 may prevent around 8 million barrels of oil per day from ever reaching the market.

The oil price crash has caused so many projects to be deferred or cancelled that Jones says, "Unless sufficient companies have the will and financial ability to invest through the downcycle, there is a real risk that supply growth may lag the eventual rebound of demand, leading to substantial price increases -- possibly as early as this year."

We sent a longer letter out this weekend about the oil markets. Please note, if you're already a Diggers and Drillers reader, you have already read our full reports on the stocks mentioned in "The Coming Oil Supply Crunch." If you're not a D&D reader, this report contains our analysis of the oil market and three of our favourite Aussie energy recommendations.

Dan Denning
for The Daily Reckoning Australia

• Wayne Swan Approves Chinalco Investment in Rio Tinto (ASX: RIO)
• Mortgage Bubble and More at Stake Between Australia and China
• Were the Government’s Stress Tests a Bogus Exercise in Deception?
• Alan Greenspan Bears Blame for Intensity of Financial Crisis
• Rio Scraps Deal to Sell to Aluminium Corporation of China