Author: Dan Denning

Australia didn’t miss out on the first part of the Global Financial Crisis and it’s not going to miss out on the second part. The second part is coming. And it could be worse than the first. That, in a nutshell, is the message of today’s Daily Reckoning.

For proof of the first claim – that excessive leverage and too much debt cost Australian investors billion of dollars – read today’s essay “Pigs at the Trough” by guest essayist Adam Schwab. Adam’s got a new book out by the same name. And he makes a great point: Australia may not have learned much from the first round of the GFC.

But is there really going to be a round two? Well, if the first incorrect assumption was that Australia didn’t have a bad debt problem, the second assumption is probably even more dangerous. It’s more dangerous because it’s the single most unexamined assumption behind much of Australia’s economic prosperity. The assumption is that we’ll always have China.

A growing number of professional investors are betting against China. It’s true that all of these investors – short-seller Jim Chanos, our friend Dr. Marc Faber, Harvard Professor Ken Rogoff – are all talking their book to some extent. We all do that all the time. But that doesn’t invalidate our arguments.

And the argument is simple: China’s economy is the Greatest Bubble on Earth. James Rickards, the former General Counsel for the famously-failed hedge fund Long-Term Capital Management, told Bloomberg that China is in the midst of “the greatest bubble in history.” He said the Chinese central bank’s balance sheet, “resembles that of a hedge fund buying dollars and short-selling the yuan.” “As I see it, it is the greatest bubble in history with the most massive misallocation of wealth,” he told the Asset Allocation Summit Asia 2010.

Students of the Austrian School of Economics would identify with the comment. Credit bubbles – and the world has arguably been in one long once since the U.S. dollar could no longer be redeemed for gold internationally in 1971 – know that credit creates excess demand. It gives producers a false impression of the consumer appetite for goods and services. Real resources are poured into providing people with products they buy with debt-based money.

When the bubble bursts, the demand goes too. This is why Australia’s government, slavishly obeying Keynesian dogma, has tried to “bring demand forward” or “support aggregate demand”
by giving away the nation’s surplus. And once it was finished doing that, it borrowed (stole) from the future in order to support demand.

But this just perpetuates the misallocation of resources (in this case, stealing tomorrow’s savings to support today’s consumption.) In China’s case, however, the misallocation of resources is even more impressive. There is massive over-capacity in commercial real estate with millions of square meters of vacancies. Whole cities lie empty.

These cities and office buildings were made with Australian iron ore and coking coal. If China’s miracle economy (regularly achieving politically mandated 8% GDP growth to support employment) is really the world’s largest collection of misallocated resources ever, then what do you think will happen to Australia’s economy?

On the verge of another big increase in contract iron ore prices, it may seem like a strange time to ask the question. But it’s probably the most important question Australian investors could ask themselves this year. “What can I do to protect myself against a crash in China?”

The possibility may seem remote. But remember, no one in the mainstream media or economics profession warned you of the GFC either, did they? Even if you think it’s unlikely or absurd, it’s probably something you should think about a bit. We’ve thought about it and we think the best answer is to retire now.

But what does that really mean? It means you should own a lot fewer stocks. But yes, that does contradict the rosy projections for Australia’s super annuation system. Australia’s super system is projected to have nearly $5 trillion in assets by 2025 according to an article in today’s Australian.

Chris Bowen, the Minister of Financial Services, spoke by video to a conference in Brisbane. He didn’t say where all the super money would go specifically. But he did say, “This might mean greater investment in infrastructure assets, provided a stable pipeline of opportunities was available.”

Now you may want your money to go into infrastructure assets. And if you do, more power to you. After all, they are tangible assets. But you can’t put a bridge in your refrigerator. Portable tangibility – wealth you can wear, store, or trade – is the name of the game as you reduce your allocation to deflating financial assets ahead of the hyperinflation. More on that Big Crash two-step in Friday’s letter.

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Australian Iron Ore Shares on China’s Menu
• The ASX Bubble, Fueled by China
• Building a National Economy Around the Housing Industry
• Australia’s Currency and its Economy Will Benefit from China’s Stimulus Package
• The Price of Oil is in a Bubble

In today’s Daily Reckoning we’ll look at why the current placid market conditions are the calm before another credit storm. At issue is whether the Federal Reserve really intends to withdraw its support of the U.S. mortgage market. At stake is what happens to global capital flows, currencies, and tangible assets if the Fed retreat sparks a rise in interest rates.

But first, what in the shillelagh is the Fed actually thinking?

The U.S. private banking cartel left the short-term price of money unchanged overnight. In announcing its decision it concluded that, “Economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

April gold futures were up $17.35.

To be clear, a shillelagh is an Irish cudgel, used to beat things or threaten drunken bar patrons on St. Patrick’s Day. Ben Bernanke is not Irish, as far as we know. But the Fed has used its digital printing press to beat 10-year interest rates into submission. That’s kept a lid on U.S. 30-year mortgage rates and prevented a further implosion in the American housing market.

Believe it or not, that means something to Australian banks. Without a full-time Aussie bank analyst on board, it’s hard for us to say how exposed the Big Four’s portfolios are to American commercial and residential real estate. But it’s safe to say that the quality of bank collateral – both here and in America – is still a big issue, and probably under-reported in the media.

In the States, the irony is that crappy subprime-backed mortgage collateral has been replaced with U.S. Treasury Notes and Bonds. Ultra safe, right? Not!

On Monday, ratings agency Moody’s warned that both the United States and the United Kingdom could lose their AAA rating on sovereign debt if they don’t get domestic finances on a more solid footing (cut spending and reduce borrowing). U.S. banks are absolutely stuffed to the gills with government debt. A ratings downgrade would wipe out a huge chunk of bank collateral. Some improvement in the last two years, eh?

As a new capital importer whose chief creditors are banks in the U.S. and the U.K., you’d think Australian banks would be worried about losing their credit lifeline. At the very least, credit would again be hard to come by if the U.S. suffers another banking shock. But in the meantime, Australia has problems of its own.

Today’s Age reports that, “National Australia Bank revealed yesterday that its $18.4 billion portfolio of troubled credit instruments had caused losses of $1.3 billion over the past two years. It was NAB’s first disclosure of the damage done by the holdings.” Better late than never.

NAB says it has an $18.4 billion portfolio of “troubled credit instruments.” With total assets of $654 billion, $18.4 billion seems like a drop in the bucket. You wouldn’t want to take an $18 billion loss. And by all accounts, NAB says its losses are under control.

But it does make you wonder, doesn’t it? Are Australian banks really as insulated from further loan losses as UK and US banks? If property prices never fall in Australia again (commercial and residential real estate) maybe so. But we have our doubts.

One useful nugget from the NAB story is that the bank as set up a new entity for its “troubled CDOs.” It’s a vehicle for NAB to quarantine its “Specialised Group Assets.” Or, the financial equivalent of locking your crazy syphilitic auntie in the attic and chaining her to the wall. She might not be going anywhere. But at least she won’t be infecting the rest of the household.

NAB has given us a preview of what we suspect the Federal Reserve is going to do. It’s our view that the Fed cannot realistically remove support from the mortgage market. Its announced intention to do so is merely cosmetic. It’s placating anxious holders of dollar-denominated assets. After all, when ratings agencies and your main creditor start publicly voicing concerns about your main product, you have to at least pay those concerns lip service.

But do you really think the Fed can afford to withdraw its support of the U.S. mortgage market? The Fed’s $1.75 trillion quantitative easing program has kept the U.S. housing market from totally imploding. A spike in mortgage rates would dry up already anemic U.S. housing sales. Prices would fall. Millions more who are hanging on for grim death would see their mortgages go under water. And they would begin to walk away.

Putting aside the implications for bank collateral, we’re talking a serious systemic collapse of the U.S. housing market. If you think that unlikely, then you’re not paying attention to just how unsuccessful the Federal loan modification programs have been. Housing prices are not recovering in America, and they won’t for some time.

So if we’re right and the Fed can’t risk tipping the housing market into apocalypse, how will it behave? NAB’s “Specialised Group Assets” are a clue. This is a distant cousin of Henry Paulson’s “Bad Bank” idea at the beginning of the crisis. It was conceived as a government-funded entity that would but all the garbage debt off the banks at some small discount to the theoretical (not market) value of the loan portfolio.

The banks would get rid of the troubled assets and have a clean balance sheet. The loans would be concentrated into a government agency that could modify the loans to its heart content, delaying foreclosure, lowering the interest rate, and lengthening the duration of the mortgage.

Mind you there are heaps of problems with this solution. How will the government agency be funded? Will it create a new class of zombie properties that are carried at above-market valuations and prevent a market-clearing price from emerging in the U.S. market? And won’t it keep millions of U.S. borrowers in debt for many years, stuck with an asset that doesn’t appreciate and a debt that doesn’t amortize?

Who knows?

But we think the Fed will find a way to fund, in some underhanded fashion, a new entity to centralise the risk of the U.S. mortgage market. Risk has been concentrating in fewer and larger institutions over the last few years. But the mortgage debt is still too toxic to be borne by any institution that wants to appear healthy and well capitalised in the market.

The Fed also wants to clear the MBS off its balance sheet so it’s free to engage in more QE (which will be necessary when U.S. deficits cannot be funded by creditors and the interest cannot be paid by tax receipts alone). So, the bad housing debt must be off-loaded.

Of course this is all speculation. But it is impossible now for the Fed and the banks to tolerate a further write-down in collateral. It must be marginalised or exempted from being carried on the main balance sheet. A great mortgage default moratorium is coming, and all the assets tied to the mortgages in question are going to be off-loaded on some credit leper island.

At least that’s how we’d do it if were trying to save a doomed system without freaking out the public and sparking a run on the dollar. Thankfully, saving a bankrupt system is not our job. Surviving it, however, is.

Dan Denning
for The Daily Reckoning Australia

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Yesterday we left off with the question of what happens to Australian stocks when the Fed ends its Quantitative Easing program later this month. It’s probably not that hard to figure out, once you think about it. The Fed has pumped over a trillion dollars into the mortgage market. Do you reckon some of that found its way into the stock market?

What’s more, if banks could borrow from the Fed at 1% and loan to the Treasury at 3%, that’ a nice little interest rate spread. That money could be dumped right back into the stock market too. It’s not exactly risk-free. But with the Fed on your side, a bank would be in the position of rebuilding its balance sheet slowly.

In any event, we reckon the end of the QE program will lead to falling stock prices. In today’s essay, our colleague Greg Canavan takes up the issue. He reckons the end of QE calls for a two-part strategy: get out of the way of falling asset prices and build a cash position is the first part. That’s where we are now.

The second part is picking through the rubble of an asset price crash for the really good stuff. In order to do this, you have to know how to value stocks. Of course if you get your timing right, you just buy a broad basket of stocks at the exact bottom and ride the elevator up. This is more of a trading strategy, and it’s what Slipstream Trader Murray Dawes is engaged in on a full-time basis

But for our part, we think the days where everyone can passively surf the index to higher and higher share prices are over. You’re better off finding companies that make good use of your capital and deliver higher returns on equity. Greg’s got his take in his article.

China’s Wen Jiabao has told the Americans to stuff it, although not in so many words. At a two-hour news conference in which he warned that removing stimulus too early would lead to second dip in the global recssion, Wen also defended China’s currency manipulation. Defying the global consensus, Wen said, “I don’t think the yuan is undervalued. We oppose countries pointing fingers at each other and even forcing a country to appreciate its currency.”

In a floating-exchange rate world, no one forces a currency to appreciate. If people don’t want to own it for yield or sound monetary and fiscal policies, it’s hard to “force” a currency to rise. You can, however, forcibly depreciate your currency by selling it and buying others. And that’s exactly what China’s been doing for years.

To be fair, China’s currency manipulation is a form of economic stimulus. It’s just less direct than Kevin Rudd’s method of giving people money. By pegging it’s currency to the U.S. dollar, China engages in a kind of perpetual devaluation. It preserves the price competitiveness of Chinese exporters. And more importantly for China’s economy, a humming export engine keeps employment high, achieving the primary goal of political stability.

But there’s no doubt that China’s policy is costing jobs in the Western world. To be fair, the U.S. is also a world-class currency manipulator. The central bank sets the price of money and, from time to time, considers how to keep the gold price from appreciating and exposing its fiat fraud.

And the U.S. is the only country in the world that enjoys the luxury of paying off its debts in the same currency that it alone can print. That is a privilege without peer in the global economy. The U.S. has enjoyed that privilege since 1971 because of its military and economic dominance and, to a lesser degree, because the rest of the world needed to do business in a stable currency and the U.S. dollar (for the most) part, fit the bill.

It doesn’t fit today. And that’s why everything is coming unstuck. As Bill shows below, U.S. tax receipts currently cover the cost of servicing the outstanding debt. But if, as we mentioned yesterday, market-based 10-year yields spike anywhere near where they did in the late 1970s, the cost of servicing the debt would eat up nearly all the current tax receipts.

After that, there’s only so much a government can realistically do. Printing money – radically devaluing the currency – is the only way out (if you’re not going to adopt Greek-like austerity measures on spending, which we don’t expect anyone in America at the government level to willingly do.)

Of course in the meantime, the deleveraging of the household and private sectors (see the 2009 in total credit market debt) is driving current demand for the dollar. That and the weakness of the euro. While these trends can see-saw a bit – don’t be surprised to see a euro rally on some kind of short-term Green band aid – it’s important to see the currency movements for what they are. And what are they?

Chimeras. The super cycle in paper money is blowing up. Currencies are moving relative to one another. But our guess is that relative to gold and tangible things, all of them will lose value. The dollar is bad. But it is less bad than the euro at the moment. And vodka and gold are less bad than the dollar.

But have we unintentionally made the argument for deflation? One reader thinks so.

Dear Dan,

“Your argument is incredibly difficult to follow because most of it seems to be a damn good argument for deflation. You finally get to the point that because deflation actually is happening, due to the failure of the private sector (the banks) to dole out the credit into the economy, then the government will do it itself. You then expect us to believe that the government will be more successful than the private sector at doing this. This is an extraordinary argument from The Daily Reckoning. Both you and Bill Bonner have been at pains for years to point out that government simply cannot do things as well as the private sector. Now you expect us to believe that they can revive credit markets. Have you gone over to the dark side? Are you now the new marketing arm of government?”

Nick M.

Nick. We don’t work for the Feds. Neither do we think the government will revive the credit markets. We think the government will replace the credit markets. What else are the nationalisations of the auto sector and mortgage markets about if not the elimination of the lender as the middle man.

It’s true that if lenders don’t want to lend and borrowers don’t want to borrow, achieving credit growth would be impossible and asset deflation and deleveraging would rule the land. But we’re advancing the argument that the response of the Feds will be to simply print money and give to people. This destroys the currency, rather than increasing the value of cash and Treasuries, as the deflationists argue.

Yes, we admit this is speculation about future government policy. But Australia previewed this strategy. The difference is that Kevin Rudd gave away money Australia had. Barack Obama is spending money out of an empty pocket. The argument against this is that the bond market would not permit such a policy and would immediately send yields sky high.

We don’t dispute this. But we think the big winner here is gold more than cash. A direct monetisation of the U.S. job market can hardly be the sort of thing that’s bullish for the U.S. dollar. And if the confidence game in the dollar is up, then the moment when people are willing to trade paper money for tangible goods at any price (the Misean “crack up” Greg cites below) can’t be far away.

Dan Denning
for The Daily Reckoning Australia

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Well Friday was a snoozer in New York. Markets didn’t make new highs. But they didn’t crash either. The S&P 500 remains near a 17-month high. And by most accounts, everything is fine in Greece, everything is fine in China, and the whole world is convalescing nicely from the last two years of crisis.

Or not.

Last week, we took up the case for why a second wave of falling asset prices would happen sooner and not later. You’d get the one-two combination of more deleveraging and falling stocks and bonds, followed by a massive government-induced inflationary campaign. Today, you’ll see why we think it is a matter of months before this happens.

First though, whose gold is China buying? It’s own!

Gold prices were down on Friday again and gold is 3.6% off its recent high. Old yellow metal is trading at around $1,101.70, according to the April futures contract. The sense of urgency over the Greek crisis has eased. And no one thinks China is going to buy IMF gold. Why?

Speaking last week at the National People’s Congress, China’s foreign exchange regulator Yi Gant told a press conference that, “currently a few factors limit our ability to increase foreign-exchange investment in gold.”

As we wrote in a note this weekend, most analysts immediately took that to mean China would not be a buyer of the 191.3 metric tons of gold the International Monetary Fund announced it would sell on February 17th. And if China were out as a major buyer of gold on international markets, speculators reckon that the gold price is in for a fall.

Yet China bought almost 50% of the gold purchased by central banks in 2009. So where did that gold come from?

China purchased 454.1 tons of gold on its domestic market last year. It didn’t have to go shopping overseas. China can buy its own home-grown gold because for the last three years in a row, it’s been the world’s largest producer. China produced over 300 tonnes of gold for the first time ever in 2009, according to the China Gold Association.

That means that last year’s domestic gold consumption exceeded mine supply. Were Chinese authorities buying above ground gold too? The number of producing gold mines in China has fallen from 1,200 in 2002 to 700 in 2009. You can see China is scrambling to produce as much gold as fast as it can.

This could be a case of a “Do as I do, not as I say.” Why bid up the price of gold on international markets when you can buy your own domestically produced gold? As a senior People’s Bank of China figure reportedly said that, “China should formulate a long-term plan and constantly and secretly increase its gold holdings… PBoC should try to buy as much gold as possible from China’s annual gold output of almost 300 tons, while the gold needed by industries and residents could be imported.”

But the case for gold is pretty simple. To paraphrase fund manager David Einhorn, if you believe monetary and fiscal policy across the world are sensible, sell gold and buy Treasuries. If you believe monetary and fiscal policy around the world are bad, sell Treasuries and buy gold. You don’t have to a cult follower or a true believer to profit from that kind of trade.

Gold made its big move in 1980. It peaked at $850 in early January. What’s interesting is that ten-year U.S. Treasury yields didn’t peak (at around 16%) until over a year later, in June of 1981. The speculators blew the top off the gold market well before they were sure Paul Volcker had a lid on inflation. Once it became clear punitive U.S. rates would kill inflation, the gold bull died.

But wait! U.S. rates went up because the Fed was fighting inflation. And it was fighting inflation because…there was inflation! How can we expect gold to rise on higher rates if there’s no inflation to fight?

The answer is that the Fed’s quantitative easing program is set to end this month. Over the last year, the U.S. central bank has spent over $1.25 trillion buying mortgage-backed securities. This has kept ten-year U.S. interest rates low and mortgage credit flowing to the American housing market. The Fed has said that program will end by the end of this month.

What will happen next? Already we’ve seen investors crowding into the short-end of the U.S. Treasury market. Treasury notes with maturities of three-years less are a nice, near-cash, highly-liquid alternative to taking any risks anywhere else. Hence lower short-term U.S. interest rates, driven partly by the Fed and partly by the market.

With the Fed set to end its QE program, we’d expect market forces to assert themselves in the bond market. You’ll get a steeper yield curve. Without the government gaming the trade, investors are going to price U.S. bonds based on the soundness of U.S. fiscal and monetary policy. In this scenario, we think gold will attract more speculators (although the big ones like George Soros have already positioned themselves for this move.)

The news that European finance ministers have agreed, in principle, to a bailout of Greece, might take even more urgency out of the sovereign debt crisis theme. And that, in turn, might even drive the gold price lower. But all these things are prelude to a bigger crisis. Papering over the insolvency of the Welfare State can only last so long – and we think the dominos will begin to fall in months, not years.

In the meantime, though, the continued de-leveraging of the private sector means even larger public sector deficits. According to flow of funds data released the by the Federal Reserve last week, both U.S. household and businesses reduced debt in 2009. The government added debt.

In fact the Fed data show that U.S. households reduced debt on an annual basis for the first time ever in the history of the data series, going back to 1946. Household debt levels shrunk by 1.7%, with mortgage debt declining by 1.6% and credit card debt declining 4.6%.

It’s obvious at the household level, where the employment picture is awful, that Americans are preparing for less spending and less income growth. They are not borrowing from future earnings to sustain current living standards. The worm has turned.

And you can’t blame businesses for reducing debt by 1.8% either. Why borrow if you’re not going to increase capital spending or employment growth? There’s a political issue here too. You could argue that business investment is cyclical and will go up eventually. But with the U.S. Congress deadlocked over health care legislation (that if passed might be repealed by the next Congress elected in November), there is a lot of uncertainty. You could also call that political risk.

Into the household caution and business uncertainty, the Federal government increased debt by 22.7% in 2009. It was below the 2008 record of 24.2%. But it’s clear that as the private sector deleverages, the government – under the misguided Keynesian assumption that it must support demand – is trying to fill the breech with borrowed money.

This sets the stage for the next episode of the U.S. dollar crisis. Right now, that may look remote, given the easing of tensions in Europe. But don’t get too complacent. The underlying fundamentals of the dollar suck. With the Fed’s QE program set to end this month, a veritable monetary Pandora ‘s Box will be opened.

Of course the Fed could just announce it’s extending its QE program. But what effect would that have on the dollar? On gold? On oil? And how does Australia fit in all of this? More on that tomorrow…

Dan Denning
for The Daily Reckoning Australia

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Here we’ve been spending all week showing how a second systemic banking collapse would broadside the Australian economy. But let’s not ignore the other pillar of Aussie economic strength: China.

What if China hits the wall too? Or what if it tightens monetary policy and puts the breaks on the great credit binge, that at least partly, has led to such a strong rebound in prices for Australian exports to the Middle Kingdom?

Inflation isn’t a risk in China now. It’s a reality. Bloomberg reports that consumer prices rose by 2.7% in February. That’s the fastest monthly growth rate in 16 months. And it eclipses the annual yield on savings deposits of 2.25%. Savers aren’t beating inflation. And if they can’t do that, they may as well spend the money. That could ignite a rising price cycle in China that monetary authorities want to avoid.

The logical step – if you’re Vulcan – is to raise interest rates and slow things down (if you can). Or, China could do the hyper-logical thing and allow its currency to strengthen against other currencies. This would immediately increase the purchase power of Chinese savers. It would make more of Chinese growth come from domestic consumption than over-producing and exporting.

But when and how China allows its currency to strengthen is up to China. It will happen when it’s in China’s best interests to make it happen. Today, we’d argue, that day is a little closer – especially when the U.S. government ran its highest-ever monthly deficit in February at $220.9 billion. Who wants to buy U.S. bonds again? Just the primary dealers?

By the way, in case you were wondering, yes we were being sarcastic yesterday about jumping into the property market – at least the Aussie property market. Converting paper wealth into tangible assets does not mean you should buy those assets if they’re over priced. And Aussie houses are definitely overpriced.

On the other hand, there are premier properties in the U.S. we’d have a look at. Most of these are not really cheap yet. But they are for sale. And that’s a change. What does it mean?

Well first, we should say what we mean. The properties we have in mind are in our home state of Colorado. They are what you might call “prestige” properties. They’re up in the mountains, zoned to prevent subdivision and numerous new neighbours, aren’t far from an international airport, but give you a kind of mountain lifestyle you’re after, if that’s the sort of thing you’re into (which we are).

What you’ll notice these days is that there is a much more liquid market for those properties now. They’re for sale, and they usually aren’t. They come on the market once every twenty or fifty years, either at moments of great distress, or when there’s a death in the family and estate taxes have to be paid.

What’s going on today? Either the owners are selling because they have to (to raise cash). Or because they want to. It’s time to retire now, in other words. Or, they see another big down leg in U.S. property coming and want to extract whatever value they can get now.

Mind you, if you’re an investor, this certainly doesn’t exclude you from being a buyer later. But it means that cashing up prior to the deflationary collapse is the best way to prepare for the collapse and buy the assets up cheaply later. Either way, we’d suggest the anecdotal evidence in the U.S. property market is that the top end is selling too.

But no, we wouldn’t touch Australian residential property with a ten-foot barge pool. But see below for a very contrarian Aussie property strategy instead.

Why even bother with property when the stock market is making its biggest rally in 76 years? In New York, the S&P 500 has made a 17-month high. Granted, stocks are making higher highs on lower volumes. It’s generally a sign that the rally doesn’t have much breadth (or life). But isn’t this just a new bull market climbing a wall of worry?

That could be the case. Our crystal ball is just as useless as the next guy’s. But it’s probably a mistake to buy the rally thinking stocks will make higher highs from here. This rally was driven by liquidity and bogus Fed money, not real earnings. The long-term of cash-flows that originated with the credit bubble are drying up. Investors are already paying too much for them.

That’s not to say you shouldn’t have a crack at predicting the future. For example, today’s New York Times has a great article called “The Lithium Case”. The article talks about how lithium ion batteries could replace nickel metal hydride batteries as the chief power source for hybrid and hybrid electric vehicles. Lithium ion batteries deliver nearly three times the amount of energy per pound as a nickel metal hydride battery.

The Times story goes on to list $1 billion worth of lithium projects being discussed in Argentina, Serbia, Nevada, China, Australia, Mexico, and Canada. It names the four biggest lithium producers in in Chile, the U.S. and Argentina. And it shows the difference between hard-rock lithium miners and lithium brines in places like Bolivia, which holds nearly half the world’s lithium reserves.

All in all it’s a great article, naming a prospective Australian stock. The problem is that the story is a year too late. Diggers and Drillers editor Alex Cowie is sitting an open position in a would-be lithium producer that’s already produced triple digit gains. And that’s just from the de-risking of the project. Future gains should come as the company produces lithium carbonate at a planned plant in China.

We asked Alex for a quick update and he said, “The Aussie-listed lithium stock we recommended twelve months ago was in its early stages, and has been more than busy since then. Since then it has ticked most of the milestones that take a company from adolescent to young adulthood. Mining has now started and buyers are already lining up. Mitsubishi has just signed up to buy the finished product, and others are waiting in the wings.”

‘As companies develop, they achieve certain goals and ‘de-risk’ as they do this. It is important to know where a developing company is in this process as to how much risk you take on. The chart below nicely illustrates how this influences the risk level.”

“Our lithium company is in development phase, and soon to cross over into production phase. This means that we are well into the lower risk stage (green area), as most of the risk has been removed since we recommended the stock. Those investors that took on the risk have been rewarded with a big jump in the share price.

“With Diggers and Drillers stocks I like to identify where about stocks are in this process, and to offer you with stocks with different risk / reward profiles to suit different risk tolerances. There are a number of things that still need to be ticked off, so there is still some upside. Then when full production is soon achieved, investing in this company will be more about exposure to the rising lithium price. Those that invested when we tipped it last year have more than doubled their money already, but I firmly believe there is more to come.”

Obviously we think Alex is on to something. But more importantly, this is what we’re talking about when we refer to Black Swans. You may lose all your money. But if you’re right, you definitely get rewarded for taking risk in these types of shares. We’d rather own a small portfolio of risks like this than a large diversified portfolio of blue-chip shares, where you get all the risk but none of upside leverage.

Of course, if we’re right about the collapse of the shadow banking system and a sovereign debt crisis, these stocks are at risk too. This is why you should strongly consider reducing the amount of cash you have allocated to shares. Selling into market strength isn’t a bad idea. Building cash position and then deploying it a small portfolio of shares and tangible assets is the next step.

There is no way we can know when the crack in the markets will come, or whether it will be a political or economic event that causes it. But it’s a comin’. In the meantime, we reckon that if you built a humpy in your back yard and filled it with banked beans, bourbon and bullets; you’d outperform the All Ordinaries for the next ten years.

Not that we’re a rating agency, but we’d give the Humpy Portfolio a Triple “bbb” rating (beans, bourbon, bullets). There are probably other tangible asset classes that will perform even better in a hyper-inflationary currency collapse: vodka, salt, pepper, cigarettes, petrol, and gold to name a few. Suggestions for the Humpy Portfolio are welcome. Send yours to [email protected]

Dan Denning
for The Daily Reckoning Australia

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So what if the possibility of a major wipe-out in shares looms? Let’s all buy houses! Today’s Daily Reckoning will continue the discussion we began yesterday. But before we can sort out what Australian investors should do in another major bust, let’s review what happened overnight.

First up is gold’s 1.27% decline in the futures markets. We’ve written about this in a special note that goes out later today. If you miss that note here’s the short version: don’t worry. The fear that China won’t buy IMF fold is a red herring. China is buying plenty of gold. But you might be surprised to find out who the seller is.

What shouldn’t surprise you is that fewer Australians are taking out mortgages to buy new homes. That’s what happens when prices rise, interest rates head up, and the government stops shovelling tax payer money into the market. You can only “bring forward” (steal) so much demand from the future.

The number of people taking out loans to buy new homes fell by nearly 8% in January, according to the Australian Bureau of Statistics. First home buyers fell as a percentage of new lending to 20.5%. That’s down from the high of May last year of 28.5%. And here in Victoria, only 525 Victorians borrowed money to buy a new home in January (see the table on page 10).

Don’t be discouraged, though. The Reserve Bank agrees with the realtors and housing industry spruikers that there is a housing shortage in Australia. RBA assistant governor Philip Lowe said in a speech in Sydney yesterday that constraints on home building are restricting the supply of homes in Australia. The shortage is one factor keeping prices up. Nothing was said about the lending boom.

Lowe said that, ”With population growth above average, and growth in the housing stock below average, it is not surprising there has been upward pressure on housing costs…If we are to build more dwellings, we need to ensure that planning guidelines and infrastructure provision can accommodate this.’”

Blah blah blah. We’re not going to rehash all of this again. But if anything, Australia has already sunk too much of its national capital into housing. Maybe investors have over-invested and locked out first time buyers while also damaging affordability. Who knows?

The river of liquidity that has floated Aussie house prices higher has its source waters overseas in the wholesale borrowing by Aussie banks from foreign lenders. This is what accounts for the financial sector’s massive share of Australia’s net foreign debt. Another global credit squeeze (the implosion of the shadow banking system) would block off those head waters. And where would that leave Aussie housing?

This is not to say or imply that homeownership is an unworthy goal. Yale Economist Robert Shiller points out in New York Times article that home ownership can promote good citizenship, a broad sense of equality, and even a sense of personal liberty in a society. That’s why in Australia and America, homeownership is THE personal financial dream.

But Shiller also points out those are cultural and not financial values. The desirability of homeownership shouldn’t be confused with the financial wisdom of it. The more leveraged a housing investment it is, the more vulnerable you are to getting wiped out on falling asset price falls. This is why nearly 16 million Americans are underwater on their mortgages.

In the mortgage boom years from 2004-2004, it wasn’t hard to get a loan-to-value ratio of 90% or higher with less than a 5% down payment. You didn’t have any equity. But the animal spirits of the housing bull encouraged people to believe prices would just keep going up.

They didn’t, of course. And instead of having equity, most of the borrowers ended up with a big mortgage and a falling asset. This is what soured so many mortgage backed securities and collateralised debt obligations. And the fact that Americans can walk away from underwater mortgages – letting the bank seize back the house, which is the collateral on the loan – in some ways made the financial gamble sensible for people. Maximum upside, zero downside.

You can’t walk away from the loan in the same way in Australia. But that doesn’t’ mean Australians aren’t gambling on higher house prices. Loan-to-value ratios are coming down as banks get more cautious (this restricts new lending as well). But they are still high. And first home buyers remain especially over-leveraged – facing higher interest rates on variable rate loans.

But you know all that. So we won’t yammer on about it. We’re just saying…house aren’t safe as houses, no matter what the RBA says.

So what is safe? Well, as a reader pointed out yesterday, cash isn’t bad. Here’s one response to yesterday’s essay:

Hi guys,

I read you latest anti-deflationist polemic today. You raised many good points.

However, you conclude that the beginning of hyperinflation may be deflation.

I think you need to tell your readers that timing is absolutely critical. Because all longs on the inflation trade may well be utterly destroyed and wiped out.

It may well be that as the meltdown unfolds, there will be a sudden and massive asset implosion that will destroy many. In this case, the governments’ RE-actions will be rather slow and ineffective initially. Hyperinflation probably comes AFTER the meltdown. So Prechter is quite possibly right.

To own cash before the governments react to the implosion may well position people to make “once in a century” purchases of hard assets. Those who can time it will do more than survive.

You guys really need to outline several scenarios IN DETAIL, with the time-flows and mechanics in DETAIL.

Cheers

John Pope

It’s a good point. We’ll deal with it tomorrow. Although it’s going to be hard to predict the future…in detail. That won’t stop us from trying! Until then.

Dan Denning
for The Daily Reckoning Australia

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Since we have little interest in joining the speculative party going on in the stock market at the moment – other than in the precious metals and “positive black swan” type of stocks we mentioned yesterday – the task of today’s Daily Reckoning is to prove why the coming collapse of the shadow banking system is not deflationary by inflationary and, among other things, bullish for gold.

If that’s not the sort of discussion that interests you, you might want to go take a powder or read a good book. These are murky waters we’re wading through. So we’ll do our best to clear them up for you. But it’s probably going to take two days. Today, we’ll look at the case against deflation. Tomorrow, we’ll look at what it means for Australia.

All good debates begin with a proper definition of terms. Rather than defining deflation in our own way, we’ll leave it up to one of its most consistent and articulate (and accurate) advocates, Robert Prechter. He’s written about it for years. But for a short course on what he’s predicting and why, check out this video.

In the video Prechter says, “The next big phase [in the cycle] is a credit implosion where people who are debtors are going to be scrambling for dollars to pay off their debts and the creditors are going to be dunning the debtors to pay them back….The scramble will be for dollars not for things.”

The investment outcome of Prechter’s scenario is bullish for the U.S. dollar and U.S. Treasury bills, where he says, “the chances of default are low.” Prechter’s argument is based on the idea – which we happen to believe – that the U.S. Federal Reserve is unable to prevent falling asset values. This would lead, by Prechter’s reckoning, to falling stock, commodity, and real estate values.

All of that seems right to us so far. The deflationary argument depends on the collapse of both the shadow AND the real (deposit taking) banking system. The shadow banking system is the murky world of credit, securitisation, and derivatives which currently supports and/or holds some $600 trillion in assets. Yes that’s trillion with a T.

Most of these are interest rate and credit derivatives. As we learned in the last two years, the big risk here is to institutions which owe and own these obligations amongst one another. In our view, the degree of interconnectedness among these obligations (they still aren’t unwound) still makes the entire global financial system vulnerable to a systemic shock and/or total collapse.

It nearly happened last time with Lehman and frankly not much has changed since. A good old interest rate spike that’s not in anyone’s model might be the sort of thing that precipitates the next crisis. After all, that’s the way these things generally begin.

You could make the argument that it shouldn’t really matter to the real economy if a bunch of global institutions find out they can’t settle their obligations to one another. Why not just forget the whole mess and start other? After all, most of these derivatives are just insurance policies of some sort. Can’t we just cancel the policy?

Probably not. These positions are held in conjunction with myriad leveraged bets on the direction of other asset prices. They are hedges. No one is going to walk away from them. But more importantly, the connection between the shadow banking system and the real banking system is much more substantial than you might first imagine.

So much of today’s funding, financing, and lending is done by the shadow banking system through securitisation and money markets and income and mortgage trusts. The real economy is tied to the shadow banking system in just the way that you are tied to your own shadow. And the real, deposit taking, depostior (taxpayer)-insured banking system is not much better off.

For example, my colleague Porter Stansberry reported today that in the U.S., 7.1% of commercial real estate loans are more than 90 days overdue. The FDIC reckons that over 700 U.S. regional and local banks are “danger” banks. The reason is that these banks own mostly commercial real estate. It’s their main asset. And unlike their money-centre big brothers on Wall Street, these banks aren’t going to be recapitalised or bailed out at taxpayer expense.

Students of the Great Depression will know that widespread bank failures led to a contraction in the money supply. Banks, more than the central bank, are the engine of money and credit growth in a fiat money system. Take away several hundred banks, and you get lenders not making loans. Money supply shrinks. Cash and Treasuries gain in value.

In fact, when you couple the wounded regional banks in the U.S., who are massively exposed to one dangerous asset class, with the potential collapse of the shadow banking system from another interest rate/liquidity/solvency shock, you begin to wonder how deflation is avoidable at all in the near future.

We have a laboured three-part answer. We’re going to lay it on you now. It begins with the destruction of the shadow banking system. It accelerates with the paralysis of the regular banking system. And it concludes with deliberate devaluation of the currency via monetary and fiscal policy to make up for a completely destroyed credit system.

It’s easier than it sounds.

Granted, it probably sounds absurd that you can have a $600 trillion wipe-out in the shadow banking system and have inflation. But there are two points to make here. First, it’s hardly believable that an institutional panic and bank run in the shadow banking system (what happened last time) would actually boost confidence by individuals and consumers in the overall banking system.

True, it might increase people’s preference for liquidity and cash. Stocks, real estate, and bonds would fall. But another swift collapse in the shadow banking system would be a hammer blow to already fragile confidence in our financial system, including the value of paper money itself.

But a more technical response is that as the shadow banking system is unable to finance economic activity and speculation, either that activity goes away (a Greater Depression) or someone else tries to fill the gap. We’ll assume for the moment the regular banks won’t do it. That leaves the government.

And in fact, that is what you had in the U.S. following the last crisis. You got an alphabet soup of Fed-backed programs to provide all sorts of credit…to students, to money markets, to car companies, to corporations. This list grows longer by the day. And what it means is that the only provider of credit in a post-shadow banking world is the public sector: the Fed and the Treasury.

Whether these are loan guarantees or outright loans or the purchase of securitised mortgages (Fannie and Freddie) it amounts to the same thing: a huge transfer and burden to the public sector balance sheet. Whether it’s monetisation or guarantees that add to Federal liabilities, both are dollar bearish. The transfer to the public sector then, results both in destruction of asset values and inflation in the currency.

But wait! You can’t have inflation if there’s no one to make loans and use the money multiplier to turn growth in the monetary base into new Federal Reserve Notes. That is, if the shadow banking system collapses, won’t this lead to the same no-risk paralysis with the big banks that has led to their holding trillions of dollars in excess reserves with Central Banks?

Why yes, it will. But this also argues for inflation. Here we’re going out on a limb. But what we’re arguing is that as the private sector is less able or willing to dole out credit into the economy, we’re entering a world where the government is going to bypass the middleman and do the job itself.

This happens in three ways. First, the government can buy securitised assets to fund non-bank lenders. The AOFM does this in Australia to support housing prices and non-bank lending to first home buyers. It’s done in the State at a much more comprehensive level. In effect, the entire American mortgage market has been nationalised with the government guaranteeing and buying trillions in mortgages.

This is the future. More nationalisation of key lending institutions. If the private sector won’t do it, the Feds will. But at great cost. Each new loan guarantee weakens the public balance sheet and the currency. Thus the retreat of the banks from credit creation hastens the day where fiscal and monetary policy are forced to be more transparently absurd and redistributive.

The second way in which the government becomes a lender is through extended unemployment benefits. The dole. In some States, it’s possible to receive 99 weeks of unemployment benefits. This doesn’t mean dole bludging has become a full time job. But it does mean that the structural changes to Western labour markets wreaked by globalisation are wage deflationary.

To us, this means a larger regular expenditure on the unemployed. The U.S. is headed the way of Europe, with higher structural unemployment. Whether it can afford to pay for this while fighting two wars, spending a $1 trillion expanding health care coverage, and preparing for an increase in entitlement payments…well you do the math.

The net result of the increased burden on the public sector in supporting private incomes is a weaker currency. It always comes back to that. And it’s true for the Euro, the Yen, and the Dollar. It’s true, in fact, for all paper money. This is why we believe the end of the super cycle in paper money is bullish for precious metals (not deflationary).

The third way in which the government bypasses the traditional banking sector to get money into the hot little hands of consumers has already been suggested by Ben Bernanke: via helicopter. And this really is the greatest argument against the deflationary theory.

In one sense, Bernanke was right. The Fed can create an infinite amount of digital dollars. It can expand its balance sheet infinitely too. It can buy assets directly. It can buy gold mines. It can probably create a market that securitises future consumer wages and pays you now for them. You literally mortgage your wage-earning future (or perhaps you get an early pay out on your social security).

The only real restrictions on the Fed’s ability to create money are rising bond yields (market discipline on currency mismanagement) and political interference. On the first issue, the Fed has some covering fire. Global investors have to own something. And right now they prefer the dollar. Unless the Fed does something radical and reckless, it can expand its role in providing credit directly to the real economy without doing huge damage to the dollar…mostly because there are so few other good options.

Obviously we think gold is a good option. But for nations like China with trillions locked up in dollar-denominated assets, what options are there?

You could argue that the U.S. Congress and the President would not allow the wilful debasement of the currency via an expanded Fed role in direct lending. But we think just the opposite. Those ass-clowns will be begging for it.

When commercial real estate blows up regional banks, we predict you’ll see the President declare victory in Iraq and Afghanistan within months, bring the boys home, and cut defence spending by 30%. The money will pour into new lending and “jobs” programs to support the economy. Fiscal and monetary policy will work hand in glove to pump funny government money directly into the consumer economy. The only result there can be is hyperinflation.

So, it’s possible – likely even – that you’re going to see across the board falls in stocks, real estate, bonds, and commodities….AND inflation. Whether we got the proper sequence right, we’re not sure. But the combination of a shattered shadow banking system, a paralysed banking system, and a terrified government certainly do add up to massive inflation.

Tomorrow, is this just an American tragedy? Or is Australia at risk too? And quite obviously, what should you do?

Dan Denning
for The Daily Reckoning Australia

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A huge storm has blown through. Startled bystanders were caught by surprise. The damage was sudden and vicious. And then as quickly as it blew in, out it went and everything seemed to be back to normal. At least that was how the weather man described Saturday’s freak storm in Melbourne.

Your editor was semi-conscious over the Pacific ocean at the time, so he can’t vouch for reports. But our 30 hour trip back from Baltimore, via Chicago, L.A., and Sydney gave us time to think. Are we just being a paranoid nutcase about the global economy? Or is the position – gradually reduce your exposure to stocks and increase your tangible asset holdings – pretty sensible in a world with soaring debt and ambitious socialists?

You’ll find our answer in just a moment. In the markets, it’s pretty sunny out. While most of Australia idled its way through Labour Day yesterday, the ASX/200 crested through 4,800. It was a six-week high for the index. And then the news got better.

Newswires report that Royal Dutch Shell and PetroChina have offered $3.31 billion in cash and stock for coal-seam-gas player Arrow Energy (ASX:AOE). There’s some consolidation going on now in Queensland’s unconventional gas sector. So what should you do?

Nothing. The time to do some speculating was in November and December of 2008. That’s when our colleague Kris Sayce tipped two of the entrants in the CSG race in Queensland. As the projects were “de-risked” the share prices went up. We phoned up Kris down the hall this morning and it is long-since out of his LNG positions.

The point? You have to be a year or two ahead of these big ideas and risk looking like a fool to make the big money on them. There’s probably plenty of safe money to be made still. And if you are not a speculator or you don’t have money you can’t afford to lose, you shouldn’t be playing the small cap game at all.

But as we contended at a dinner in Baltimore last week, the best reason to be in equities at all right now is for the chance to make five or ten times your money. These are Taleb’s positive Black Swans, the low-probability, high-magnitude events that are actually good for your portfolio. Your much better off owning a portfolio of disruptive technologies or prospective ore bodies leveraged to higher commodity prices than blue chip stocks. Why?

The share market as a method for long-term, safe wealth-generation is a dead letter. That is, it ain’t gonna happen that way anymore. Stocks are up nearly 70% from their March 9 lows of last year. The reflation rally engineered by monetary and fiscal expansion in the last year has merely papered over some huge structural weaknesses in the global economy.

But more importantly, the share market is at risk now for a big fall as it was in the middle of 2007 when the Bear Stearns story broke. Since then the perimeter of global markets has gradually been overrun by the forces of wealth destruction. Investors retreat into a smaller and smaller circle of “healthy” institutions and currencies – which only heightens their risk to further asset write downs.

The basic problem is that the global illness of too much debt has been remedied by more debt, which is no remedy at all. France and Germany may bail out Greece. But who will bail out Europe? And who will bailout the United States when public debt could rise to be 716% of US GDP in the Congressional Budget Office’s alternative scenario (see page 20 for the figures).

Of course if you really think stocks are cheap now, your best bet would to be buy them and hold them. It’s worked before. But we wonder, given the demographic forces in the Western world, if there is simply going to be more sellers than buyers in the coming years as the boomers liquidate.

Granted, we’re arguing for a change to the prevailing conventional wisdom of the last 30 years. But hasn’t the last two years given you every indication that the world really is different now and that what worked for you before in investment markets may not work again?

Or if you prefer the argument in more concrete terms, have a look at what Karl Denninger has said about the systematic balance sheet fraud going on in the United States. Dennigner shows that the suspension of market-to-market rules for U.S. banks did not – surprise surprise – lead to any improvement in asset quality.

But it’s only at liquidation when the banks are taking over by the FDIC that the banks admit they’ve been carrying loan portfolios at much higher valuations than market prices would suggest. They only realise their losses when they are technically insolvent on their fictitious asset values. You wonder how many U.S. (or Australian) banks are doing the same thing.

Denninger reckons, based on the write-downs in assets on the firms seized by the FDIC, that total unrealised losses on bank loans could be between $1.5 and $3 trillion. Imagine what that would do to credit markets. And if the Fed tried to paper it over, imagine what that would (will) do to the dollar. Now imagine having the chance to buy gold at $1,124 an ounce.

Of course the underlying assumption to the recovery narrative has been that the bank collateral would always recover in value once the real estate market recovered. And that would happen with the passage of time, low interest rates, and short memories.

But in America at least, it’s nowhere close to happening. If anything, a second and destructive down leg is coming. This is why banks continue to hold large excess reserves at the Fed. They know they’re going to need it.

The underlying belief to all of this is that the credit boom has already gone bust and assets won’t fall any further. You see this fiction over and over in America with the ramshackle and largely failed attempts to modify mortgages with longer terms and lower interest rates. But the basic problem – the house just isn’t worth that much – is ignored.

Here we are, then, a year into the rally. The great central bank counterfeiters of the world have pumped up prices – presumably so those in the know can sell at a smaller loss, or in the case of the investment banks, at a substantial profit. But the real economy remains massively burdened by debt. For the rest of this week, we’ll look at why we think the end-game to all this will play out over months, and not years. And why it won’t be deflationary. Until then…

Dan Denning
for The Daily Reckoning Australia

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Has anything important happened?

The Aussie market finished up Thursday with the 5th day of gains in a row. It’s a nice little run. But is it a bull market? If it is, it would contradict everything we’ve said about everything, and make us look very foolish (although not for the first time).

Here in the States everyone is keen to see the non-farm payrolls report. It comes out on Friday. Anecdotal evidence (what people say) suggests that the employment situation here is still pretty bad. But government statistics can say pretty much whatever you want them to say.

If you’re looking for the internals of the market, try breadth. That is, if you want to judge how intrinsically strong a rally is, look at how broad it is. Is it just concentrated to a few of the big stocks (banks and basic material, for example). Or are all stocks marching up in lock stop on higher earnings and higher valuations. Is the equity premium visible?

Take a look at the chart below. It’s the advance-decline index on the New York Stock Exchange from early 2007 unto today. The scale of the chart is less important than the trend. The index tracks the difference between advancing and declining issues on any given day. When there are more advancers than decliner, the index is bullish. When there are more decliners than advancers, it’s bearish.

If you’re trying to use the A/D ratio as a predictor of what’s next (and who isn’t?) then what does it really tell you? The chart above shows you that market breadth started to deteriorate months ahead of the actual high in the Dow Jones (which came later that year in October.) The June-July revelations that two Bear Stearns funds were in trouble accelerated the deterioration.

The March 2009 low in the A/D ratio more or less coincided with the low in the index. There wasn’t any advance warning from the index. That’s likely because the March lows were reversed by the active (and perhaps direct) support of the Federal Reserve via interest rates and a program of Treasury bond buying.

Whether the Fed worked a way, via its primary dealers, to get stocks moving too (another word is ‘manipulation’) is an interesting but ultimately unanswerable question. The important point here is that nothing in the fundamental mechanics of the market indicated a reversal. It was an external event.

And what about now? The A/D ratio is going up, up, and away. It could be that corporate cash positions are solid, the employment market won’t get worse, and that the end is in sight for the U.S. housing market. Some combination of these factors could explain the steady advance of stocks since last march. But maybe not.

Our guess is that this is simply evidence of the Fed’s Great Reflation (see Marc Faber’s March Gloom, Boom, and Doom Report). All the new money created by the Fed, and the new lines off credit made available to U.S. financial institutions, made its way into the stock market by force off habit. It was easy to borrow and there was only one sensible place to put it: stocks.

But is that still the best trade going now?

No.

Your best bet, as we’ve been saying all along, is to retire now. Gradually liquidate your stock portfolio and pare it down. People are buying stocks now because it’s what they’ve always done and what they’re still told to do. But as a wealth survival strategy, the stock market is a death trap.

You should, by our reckoning, own a small portfolio of stocks leveraged to positive Black Swans (low probability but high magnitude events that drive a share price higher…like the discovery of a new ore body or the development of a new drug). These are the sort entrepreneurial ventures that will create new wealth. A portfolio of these business experiments is like a call option on the world we’ll live in after governments have gone bankrupt and lost the ability to perpetuate the follies of the previous credit bubble.

But for now, the public sector campaign to bail out the plutocrats in the private sector is in full force. And in the meantime, the public sector in Europe is trying to save itself. Markets in Europe have reacted with contented indifference to the affair in Greece. Has anything important happened there?

Well, the Greek government presented a plan to cut spending by $6.8 billion. If effected, it will reduce the deficit-to-GDP ratio from 12.7% to 8.7% in the next year, which is pretty ambitious. The Greeks plan to do two things: raise revenue and cut spending.

The Greeks will raise taxes on fuel, tobacco, and sales taxes. And if the communist unions don’t derail the plan, bonus payments to public sector servants will be cut by 30% and wages will be frozen for civil servants.

If Greece is having a fiscal crisis, why is anyone in the government getting a bonus payment at all?

The Greeks have $20 billion in sovereign debt maturing in April and May of this year. The negotiations between the Greeks and the rest of Europe are trundling along. But to what end? The Germans refuse to pony up for a bail out. But will the EU sacrifice Greece to save the Euro as a currency?

Nobody knows. But our main point today is that you should not think Greece has gone away. It’s true that since February, the cost of insuring sovereign governments against default has fallen. According to the folks at Bespoke Investment Group, only Vietnam, Argentina, and Egypt have seen wider credit default swap spreads in the last two months.

So we have a pause in the crisis-think. Markets rally on reflationary monetary and fiscal policy. But the underlying structure of the fiscal welfare/warfare state is badly damaged. This is still an excellent time to reduce your exposure to stocks and add, on the dips, your exposure to precious metals and precious metals equities (in full knowledge that even gold stocks are going to decline on another general decline in stocks).

It’s probably not just stocks you should re-think, though. Last week we mentioned that fund manager Colonial First State (owned by the Commonwealth Bank) has told investors in its Mortgage Income Fund that it could be as long as four years before they get their money back. The average age of the 17,000 investors in the fund is 74 years old.

Redemptions in the $850 million fund were frozen not long after the Federal government guaranteed bank deposits. High-yield mortgage trusts are not bank accounts. Investors and pensioners who treated them like high-yield bank accounts – because that’s how they were sold – were suddenly not generating needed income on precious savings. And now the savings are locked up.

But it wasn’t just the government guarantee that pummeled the mortgage and property funds. It was the underlying securities. On February 9th, Colonial announced it would wind down the Mortgage Income Fund because the bad debts on some of the underlying property loans were, “too big to manage.” It has another $1 billion of pensioner savings locked up in similar funds.

Now without knowing the composition of assets in the other funds, it would be hasty to say that mortgage funds in general are lousy investments. However we’re inclined to think just that. But more importantly, there’s a point here about having your money locked up in large pools of capital these days.

These large pools of capital – mortgage funds, property funds, super funds, 401(k) plans in the States – are extremely attractive to people who need capital. Call it “captive capital.” Banks covet it because it keeps them cashed up when facing declining asset values in commercial and residential property.

Governments covet the capital even more. It’s a ready source of funding for government deficits. If you can compel banks to buy government bonds (via credit requirements), or if you can compel savers to own government bonds for “safety” and “annuity” reasons, then you can force people to fund your deficits. That means you may not have to cut spending so deeply that you lose an election because of it.

So what should you expect and what should you prepare for? Higher taxes are a given. “Nutter expected to tax sugary drinks, set trash fee,” reports a Philadelphia newspaper. The Nutter in this case, quite appropriately, refers to the Mayor. He’s taxing fizzy drinks and garbage to raise extra money for the city. At the city and state level, you can expect a lot more of these creative ways to finance spending – along with cuts in services.

This is part and parcel of the over-reach of the Welfare state. If the U.S. Warfare State has over-reached in Iraq and Afghanistan, it’s been over-reaching domestically for years with programs paid for out of an empty pocket. The same is true in Europe, Japan, and increasingly, in Australia.

Some places are better off than others. Australia has a relatively smaller public sector debt burden. But the country overall, if you look at the net foreign debt, owes its prosperity to foreign lenders. You can expect the strain on public sector finances to only increase in the coming years.

All of that suggests, to us anyway, that you should re-think your reliance on traditional income and savings vehicles. Look for changes to be made that make it harder for you to get at your money. Or, if you can withdraw it from certain accounts and schemes, you will do so at a massive penalty. Governments need capital. And when they can’t compel you to use yours to finance their spending, they are going to get at least a pound of flesh if you choose to remove your money from the system.

What should you do instead?

As we said above, a small portfolio of stocks – business projects leveraged to very high returns – is nearly the only good reason to stay in stocks. The other good reason is that as governments monetize debts and confidence in paper money fails, stocks may beat inflation a lot better than cash. The rally of the last year is evidence of that.

Next week, when we get back to Australia, we’ll take on the main objection to all of this: deflation. That argument is simple. As the global debt burden becomes too heavy, it will crush asset values, leading to falling asset prices across the board, including precious metals. We have too many objections to this to list here. But stay tuned next week. Until then!

Dan Denning
for The Daily Reckoning Australia

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No one was really surprised. But the Reserve Bank of Australia went ahead and raised the cash rate yesterday to 4%. Stocks shrugged it off, but mostly in indifferent fashion. How will it affect the first home buyers? Hmmn.

Speaking of housing, the ABS reports that building approvals fell 7% in January from December. “Experts” were expecting a one percent increase. It was the first time approvals have fallen in five months. But with the expiration of the first home buyer’s grant and rising interest rates, it shouldn’t be that much of a surprise.

Yesterday’s news came from the world’s most akwardly named bureaucracy, the Australian Bureau of Agricultrual and Resource Economics, henceforth to be called ABARE. The group published its quarterly commodity outlook. It tells you how much Australia can expect to make from selling the family: silver, iron ore, and coal. Its conclusions were kind of surprising.

The main conclusion was that Australia would see rising export earnings on higher volumes but moderating commodity prices. In other words, the China boom will drive export volumes for the next five years. But you won’t see any more mammoth increases in commodity prices.

Before we dive into the data, a warning: these kind of forecasts are usually worthless. Not that they aren’t carefully prepared. But you just don’t know what’s going to happen in the world. You can be motoring along during a big boom and whammo! A credit depression hits and reveals a 25-year misallocation of resources in the consumer economy.

But for the sake of determining if Australian resource stocks are cheap or expensive to projected earnings, let’s see what ABARE thinks earnings will be like. As you’ll see, the big growth will come fromm mineral and energy commodities, with base metals giving a big kicker in the next year especially.

ABARE reports that “The value of Australia’s commodity exports is forecast to be around $186.8 billion in 2010-11, which is an increase of 15 per cent from a forecast $162.5 billion in 2009-10. The value of Australian commodity exports in real terms is projected to rise over the outlook period. By 2014-15, Australian commodity exports are projected to be around $211.4 billion (in 2009-10 dollars), which is 30.1 per cent higher than forecast for 2009-10.”

You’re looking, then, at about 7.5% annual growth in the value of Australia’s agricultural and mineral exports. That’s slightly less than China’s annual GDP growth rate (also a suspect number). But it’s certainly a lot healthier than growth rates in the rest of the Western world.

ABARE says that in the next 12 months, export earnings will be driven by 19.8% increase in energy commodities (oil and coal, but not including uranium). Metals and bull commodity export earnings will rise by 17.6% to $87.9 billion. Iron ore and coal are the big winners here. For this year, higher prices will account for the increase.

But ABARE’s rather muted conclusion is that increased volumes are going to drive earnings growth, and not just underlying gains in commodity prices (which will begin to be weighed down by increasing global production). For stock pickers that means you can’t just find stock that you think are leveraged to higher prices. You’re also going to have to find low-cost producers. And you are going to have to find projects with the best economics.

Good thing we’ve got Alex on the case at Diggers and Drillers. He’s been on baby duty at home with his newborn. But he continues to check in with reports and is back on the case full time next week. We’ll keep you posted.

We’re taking the projections somewhat seriously. That could be a mistake. For example, take ABARE’s estimates of crude steel consumption and production. Both are predicated at average annual growth rates in the Chinese economy of just under 10%. And both assume China’s resource-intensive industrialisation has years to run, rather than having already run its race.

It’s quite possible we’re much closer to the end of the China-driven steel boom than a next higher phase. But ABARE’s numbers are astonishing. It predicts that global steel production will have grown by 30% between 2008 to 2015, from 1.347 billion tonnes consumed in 2008 to 1.774 billion tonnes in 2015.

ABARE is projecting a 79% growth in Chinese crude steel production during that same period. In fact, by 2015, according to these figures, China will consume 812 million tonnes of crude steel per year. That’s more than the U.S., Brazil, Russia, the 27 nations of the European Union, India, Japan, and Korea combined.

This either shows how cataclysmic things are going to get in the industrial West (and Far East). Or it shows how wildly unsustainable projections of Chinese steel consumption are. How many more empty cities can you build? How long can you sustain fixed asset investment at 30%+ of GDP, especially when much of it is in commercial and residential real estate?

On the production side – and this is the part that has the most to do with Australia’s iron ore and coking coal industries – ABARE estimates Chinese steel production will be 880mt in 2015. The rest of the world combined will be 712mt. This means China will be a net steel exporter, if ABARE’s production and consumption figures for crude steel turn out to be right.

Our guess is that they will be sensationally wrong. China has its own credit boom malinvestments that are bound to blow up in the next few years. Precisely when doesn’t really matter. And don’t forget the fact that the Global Financial Crisis has smoothly shifted into a sovereign debt crisis. This too has the potential to knock out the legs from under the world economy and hugely reduce resource demand.

“‘Prepare for a very difficult economic time, which you will not be able to escape,’” said Hans Hoogervorst, the Netherlands Authority for Financial Markets chairman. He was speaking at an ASIC sponsored gig in Melbourne that sounded pretty interesting.

He said that “‘Even for a country that has been so soundly managed as Australia, this will have consequences…The problem is that there is now too much on the shoulders of government. They have basically taken on all the problems caused by the financial crisis, with the effect that most of them are in really, truly horrible budgetary shape.”

Large government deficits usually mean slower growth. For one, government borrowing robs the private sector of the capital it needs to resume growing. Australia doesn’t have a lot of surplus domestic capital to begin with. But really the problem is what it always is: a world built on too much debt. It’s gotta give.

Yesterday we promised to tell you about how some Australian savers/investors are being locked out of their money for as much as four years. Look for that tomorrow. We’re runing out of time and space today.

The next few days should be busy but insightful. We’re meeting with all the gathered editors from Agora Financial, a sister company here in Baltimore. And later in the week, the investment board of the Bonner Family Office meets. We’re on the board there and are eager to here what other investors from all over the world are looking to buy or sell right now.

In the meantime, it’s amazing how cheap things are in America. Coffee…haircuts…food. The dollar really is cheap right now. If we didn’t know intimately how screwed up America’s finances were, we’d think it was a buy.

Dan Denning
for The Daily Reckoning Australia

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It looks like Kris Sayce will be buying us those three beers after all…

You’ll recall that the wager we made last week with our colleague down the hall was whether or not the Fed would raise the Fed Funds rate in the next three months. Your editor – based on his vast knowledge of the Fed – reckoned no. Kris reckoned so.

So far, it looks like we’re going to win. Ben Bernanke fronted Congress yesterday and called the U.S. economic recovery “nascent.” That seems pretty generous, given that January new home sales fell 11.2% from the month before the lowest-ever level on record. That sounds like a second housing bust, more bank losses, and the increased deleveraging of American households.

Markets didn’t hear any of what we heard though. The S&P 500 was up nearly one percent. And to be honest, we know as much about the future as the next guy: nothing. It could be that the Fed chairman is right and consumer demand will slowly recover and things will be rosy again.

But remember, the central bankers telling us that America’s recovery is “nascent” and that Australia will benefit for many years from a “very big” investment boom in the resources industry are the same blokes who did not give you a single warning about what was coming in 2007 and 2008. Why is that?

They weren’t looking hard enough. The blame for the global bust has fallen on too much leverage and too much speculation. A deeper blame falls on the structure and the ethics of the modern economy itself. It seems to favour debt and speculation and reward money shufflers. But that doesn’t tell the whole story either.

The whole story begins with the manipulation of interest rates. The credit cycle – in this case lowering interest rates to avoid the necessary liquidation of bad investments – is what turned the dot.com crisis into an American housing crisis. Securitisation and credit default swaps turned it into a global problem infecting the whole financial system.

But the central bankers refuse to acknowledge that booms and busts are predictable if you study the credit cycle. Maybe they do understand this, of course. They just don’t want anyone else to understand it. How else could Alan Greenspan take himself seriously by telling us this is the worst financial crisis ever – but not acknowledging his indispensable role in making it possible?

However maybe we’ve been couped up in our St. Kilda redoubt for too long. So we’re hitting the air and on our way to freezing, snowy, Baltimore to meet with some colleagues and discuss what to do. We already have a plan.

In the meantime, Australian markets are motoring along contentedly. In fact the economy has recovered so nicely that several investment banks are worried that the government deficits are going to be smaller than expected and that – get this – there won’t be enough government bonds to satisfy market demand.

Quick! Borrow more money so the bond market is happy!

Figures from Deutsche Bank and Citigroup both show the annual fiscal deficits being smaller than expected through 2016. These smaller deficits (they’re not going away entirely) are presumably the result of increased royalty income from the commodity boom, a favourable terms of trade, and solid GDP growth. Spending probably won’t go down much, if at all. But national income will go up. Anyway this is what the banks have looked into the future and seen.

Yesterday’s Financial Review even mentioned the possibility that a shrinking government bond market would be a problem for Australian banks. That’s because a new regulation proposed by the Australian Prudential Regulatory Authority (APRA) would require a certain percentage of bank assets to be made up of high credit quality bonds.

Only government bonds (sovereign debt) would appear to satisfy the requirements. This is convenient for big borrowing governments. A similar rule in the UK is under consideration and it provides the government there with a similar captive market for its bonds. The banks must, by law, own some government debt.

But what if Australia’s government isn’t borrowing enough to meet bank requirements for “safe” government debt. To be honest, we’re not losing any sleep over that problem. Australia’s demographic dilemma is not as acute as other countries. But with an ageing Baby Boomer population, you can surely expect higher aged pension and health care expenses at the federal level. That’s going to take some borrowing.

But yesterday’s article – and we can’t give you a link to it because there isn’t one – said an alternative is being discussed. You’ll never guess what it is…mortgage backed securities!

No kidding. With a straight face, someone has apparently suggested that the best way to improve asset quality for Australian banks is to make them buy mortgage backed securities. Are you kidding?

The banks set up other companies to engage in the non-traditional lending business precisely because they don’t want that stuff on their balance sheets to begin with. It’s hard to imagine you’d improve the quality of bank assets by forcing them to take on more assets that are collateralised by real estate. Remember…that did not work out so well for American banks did it?

But then, Australian house prices never fall. So perhaps collateral securitised by Aussie houses is, well, safe as houses. But you wouldn’t want to be the solvency of the banking system on it, would you?

Dan Denning
for The Daily Reckoning Australia

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What about China, though? RBA governor Rick Battelino told a group of people in Sydney last night that despite the interruption of the GFC, “the underlying dynamics of the resource boom are starting to reappear. Those dynamics, presumably, are China’s growth and the investment required in the domestic resource economy to increase production of coal, iron ore and everything else China buys from Australia.

Battelino says, “It’s hard to put a finger on exactly how much investment is going to take place, but I don’t think it’s unreasonable to expect mining investments to rise to 6 per cent of GDP over the next few years. That would be about twice as high as it got to in the previous boom. It’s a very big boom.”

He reckons the boom could last into the 2020s. “Past booms do not seem to have lasted more than about 15 years before resource depletion or international or domestic developments acted to slow economic activity and bring the boom to an end.” But fear not!

“On this occasion, the growth potential of countries such as China and India suggests that the expansion and resource demand could continue for an extended period. Whether this eventuates, however, will depend on, at least to some extent, the economic management skills of the authorities in these countries, not to mention our own.”

But there are plenty of sceptics on the China story already. Our old friend Marc Faber told Bloomberg that, “It does not make sense for China to build more empty buildings and add to capacities in industries where you already have overcapacity. I think the Chinese economy will decelerate very substantially in 2010 and could even crash.”

And what would that mean for Australia and Aussie stocks? Quite a lot, of course. Faber says that, “If the Chinese economy decelerates or crashes, what you have is a disastrous environment for industrial commodities.”

That couldn’t be any clearer.

But maybe we are overly pessimistic. We’re hopping on a plane tomorrow and headed to the other side of the world to discuss these and other matters with some old friends who’ve been in the investment game for a long time. If they are more sanguine about things, then we’ll be really worried.

Dan Denning
for The Daily Reckoning Australia

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It’s a strange old world. An auction of $44 billion worth of two-year U.S. Treasury notes went off without a hitch. Even the yield on ten-year U.S. notes fell as investors…did what? Expressed their preference for short-term U.S. debt rather than say, Greek debt or stocks in general. Both the S&P and the Dow were down.

Why is that strange? Well, it’s only strange if you describe the move as a “flight to safety.” U.S. bonds are anything but safe, once you take a good hard look at the nation’s balance sheet. But maybe they are relatively safe. That is, they are better than Greek or other sovereign bonds.

But as we’ve said before, the rally in the U.S. dollar and in U.S. sovereign debt is driven more by a preference for short-term liquidity than anything else. You can tell this is true because for longer-dated bonds, demand is weak. No one wants to lend to the Nation State for 30 years anymore.

“Longer-dated U.S. Treasuries fell on Monday as relatively soft demand in an auction of 30-year inflation-protected bonds added to uncertainty over the market’s ability to absorb record new issuance this week,” reports Chris Reese at Reuters. He writes that, “The 30-year Treasury inflation-protected securities sale marked a bit of a lacklustre start to this week’s round of $126 billion of U.S. government debt issuance, producing yields that were well above expectations.”

“So what?” you say. “Who cares if the U.S. yield curve is getting steeper? What does it matter to Australia if global investors prefer short-term U.S. debt and not the longer term or inflation adjusted issues? Big deal!”

Well, anything that brings us closer to sovereign debt crisis in the U.S. certainly IS a big deal. The next phase of that crisis is much steeper yields at the long end. That’s the part of the market the Fed doesn’t control (at least directly). For example, much steeper ten-year yields would be bad for the U.S. housing market. Thirty-year U.S. mortgage rates key off of the ten-year yield.

What’s bad for U.S. housing is bad for U.S. banks. And what’s bad for U.S. banks is probably bad for a lot of banks, including Australian ones. But we’ve hoed this row before so we won’t do it again.

Dan Denning
for The Daily Reckoning Australia

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Your editor is preparing for an unplanned trip back to the United States. Details about why will follow in the coming days. But for today, we’ll keep our reckoning short and sweet.

“I’m going to Thailand first to study Muay Thai fighting because why not? I’m young and it’s cool. And then after, I’m going to go to Greece. I figure I could find some embassy work there and I hear they’re going to go back to the Drachma. Things are going to be cheap!”

You can tell a natural contrarian when you meet one. And we met one yesterday in the Prince of Wales at lunch. Mind you we weren’t drinking our lunch. We were watching the U.S. vs. Canada Olympic hockey game. And, in exchange for twisting the caps of some stubborn bottles, the bar maid had given us permission to eat a chicken Caesar salad while not drinking beer.

A young Canadian man from Saskatoon moseyed on up to our table and asked about the score. Canadians are some of the politest people in the world. But when it comes to beating the U.S. in hockey, they do not stand on ceremony. But after we exchanged unpleasantries we got to talking about our relative experiences in Australia.

“I love Melbourne,” he said. “People are laid back. But it’s really expensive you know? I can’t wait to get to Greece.”

“Do you speak Greek?”

“A little. I mean, my family isn’t Greek. But I’ve always liked it. And I have a political science degree. So that should help.”

“Do you think it’s the best time to go there?”

That’s when he told us he thought things would be cheap. We probably should have offered him a job at that point. Risk taking and a sense of adventure are at a premium in today’s work force. Plus, you can never have too many Muay Thai fighters around.

But whether he’s right about Greece or not remains to be seen. Stock markets are meandering through February as if no clear signal about the pending sovereign debt crisis has been issued. Everyone seems to believe – assuming they are thinking at all – that Europe will get its fiscal house in order and adopt an easy monetary policy to compensate.

The natural trade is to sell the heck out of the Euro. Everyone’s doing it. Sentiment is so bearish on the euro we’re half inclined to buy it, but just as a bounce back trade. On the other hand, maybe sentiment on the euro, and on paper money in general, is not nearly bearish enough.

The euro itself is a symptom of the big trend of the last 100-years: centralisation. Centralise the production and distribution of electricity…of oil…of manufactured goods (China), of financial services (big banks), of health care, and even of how we live together (more people living in big cities, fewer in the country).

But if we’re witnessing the breakdown of centralisation – for a variety of reasons – the breakdown in centralised banking and paper money (a corporatist mash up between the banking cartel and its minions in government) then buying and selling stocks is not a sufficient wealth protection strategy.

More decisive action is required. This is exactly why we’re headed back to the States for a week. We’ll tell you more as the story unfolds. Until then…

Dan Denning
for The Daily Reckoning Australia

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Free beer. It’s even better than free money. Beer you can drink right away. Money has to be exchanged.

Your editor is thinking about beer because he’s going to win some of it from Kris Sayce at Money Morning. The Sayceninator was one of several colleagues last week who expressed the view, if we understand them correctly, that the Fed’s decision to raise the discount rate last week was a sign of monetary tightening.

This triggered a flurry of speculation what the net effect would be. Sell equities? Sell bonds? Buy bonds? Sell gold? Buy gold? What what what?!!

Our response: don’t believe the hype.

So we made a bet with Sayce: if the Fed raises the Fed Funds rate at any time in the next three months, or even fixes short term rates at 0.25% instead of today’s free-floating range, we’ll buy him three barley pops. If the Fed Funds rate goes nowhere, that’s more beer for us.

The market seems to agree with us, so far. After an initial fainting spell on Thursday, it remembered itself and gathered its composure. Granted the S&P and Dow didn’t do much on Friday. But they didn’t crash, either. And today Aussie stocks have held their nerve as well and sprinted higher.

The simple, unarguable, world-conquering, completely undeniable, not-to-be-disputed truth is that the Fed cannot raise the Fed Funds rate without doing serious damage to an American real estate market that’s already in intensive care. We would bet a keg of Heineken on it. Why?

A hike in the Fed Funds rate would do more damage to the collateral on the books of America’s banks. It would wipe out more (already thin) capital cushions. And it would undo the work the Fed has done in other markets (securitisation) to get credit flowing. The Fed can’t risk all that.

It’s not the big money-centre banks in Wall Street you have to worry about. It’s the smaller regional and community banks. The Federal Deposit Insurance Corporation shut four more of them over the weekend. That’s 20 for this year, which is a lot less than the 140 last year. But if you wanted to see a spike in U.S. bank failures, you’d definitely raise interest rates.

Besides, why bother? The Euro is in slow-motion imploding as a currency experiment. The dollar, as the not-euro, is getting a bid. At the very least, the dollar bears are closing their shorts for now. The U.S. dollar index is still testing resistance at around 80. As Murray said last week, if it can hold 80, the next stop is 84. That’s consistent with a much weaker euro.

All of this happened without a puny 25 basis point rise in the discount rate. If the Fed really wants to get tight, it can shrink its balance sheet and quite directly supporting lending and asset prices in any number of markets. Until you say a shrinking balance sheet, don’t think Ben Bernanke has suddenly turned in Paul Volcker.

Long-only stock fund managers can sigh a breath of relief then. The easy-money conditions that have led stocks up since March of last year are not disappearing any time soon, as far as we can see. Not that you have an all clear to buy Aussie stocks. But where does that leave us?

It leaves us pretty much in the same position we were to start the month: having no idea what the future holds. We know what SHOULD happen. More global deleveraging ought to lead to lower prices for stocks and real estate and even commodities. We’d expect a bear market in paper money that would have a corresponding bull market in precious metals and precious metals equities.

This is how we resolve having a fundamentally bearish position on the economy but still recommending you own some stocks. Yes, it’s risky. But it is a strategy nonetheless.

Still, we can’t help but think that official policy makers here still underestimate how vulnerable Australia might be to another credit shock. No one is worried about Australia’s sovereign debts because, by comparison, they are a smaller as a percentage of GDP than many other nations. The country’s debt burden is lighter, and thus, easier to service.

But if there is another credit crunch in America due to falling commercial and residential real estate values – how eager are American and European lenders going to be to to lend money to Australian banks? Won’t they want to conserve capital instead? And then where will the money come from?

This leads us back briefly to a few more facts about Australia’s net foreign debt. And here we mean the debt owed by households and corporations too, not just sovereign debt. Based on the maturity schedule of the debt and composition of lender countries, we’d say Australia could have a massive debt shock rather easily.

That would put the Federal government in the position of lender or debt guarantor of last resort. And THAT could quickly lead to rising government debt-to-GDP ratios-exactly the same kind that blew out in America and Europe in the last two years due to similar circumstances. But where’s the proof?

First, have a look at the chart below. It shows that the UK, the US, and Japan make up combined make up 49% of Australia’s foreign debt country. To the extent the banking resources of these countries will be dedicated to saving their own hides in a second credit crisis, you can assume they might not have as much money to lend here. That leaves a huge burden on the remaining lenders, including the 32% classified as unallocated (whoever that is).

But the problem is more serious when you read about the maturity schedule of Australia’s foreign debt. According to 2008 data, over $400.1 billion dollars of Aussie foreign debt – or 35.4% of the total – matures in 90-days or less. Nearly half the debt total – $514 billion – matures in one year or less. What does that mean?

We think it means two things. First, that’s a lot of debt to roll over in a short period of time. It gets even harder to do when your lenders have bigger fish to fry. Second, it makes your borrowing a lot more interest rate sensitive. You may indeed be able to borrow. But it will cost you a lot more to do so. And you can be sure that if the Big Four Aussie banks have to pay higher rates internationally, they’re going to pass on those rates domestically. We’ll see what happens to housing finance commitments then.

One guess is that the government will have to pony up more money in the residential mortgage backed securities market (RMBS). The government has pumped more than $8 billion into the market since 2008, according to Danny John in today’s Age. This means the housing boom is being propped up by government borrowing to support lending.

There are more than few outrageous aspects to all of this. For one, it looks to use like many of the non-traditional lenders who are financed via the AOFM are loosely affiliated with Big banks anyway. It’s a way for the Big Banks to practice high-risk lending and sell the loans to the AOFM, all in the name of making housing “affordable” to people whom the Big Banks won’t lend to on their own balance sheet. That’s pretty shady.

The issue for Australia is whether the back-door rigging of Aussie house prices by the AOFM will eventually endangers Australia’s ability to pay its sovereign debts. Granted, $8 billion here or there hardly seems like the sort of thing to break the national bank these days. But it’s the trend that concerns us.

That trend is that in markets where traditional financiers and lenders won’t participate, the government is forced to come in and put the public balance sheet on the line. There are few markets more politically important than housing. You can see why the government is committed to supporting prices even if it means supporting friendly affiliated non-bank lenders with billions in the securitisation market when few others will.

But our question this week is what happens to that $500 billion in foreign debt with a maturity date of less than one year? What happens in another credit crunch if Australia’s main borrowers – and let’s be clear it’s the big banks and financial companies we’re speaking off – have to pay more to borrow (assuming they can get it?)

One obvious answer is that the federal government will have to step in. This could lead to transfer of private liabilities on to the public balance sheet here in Australia in just the same fashion it happened in the U.K. and the U.S. And for a nation already carrying a large foreign debt burden, it might not take much for such a crisis to put the federal finances on incredibly unsteady ground.

But maybe we’re just grumpy because it’s Monday.

Dan Denning
for The Daily Reckoning Australia

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It appears that the scramble for financial lifeboats has begun, at least at the currency level. In today’s Daily Reckoning, we’ll show you how the U.S. dollar strength is another way of reading the euro its last rites as a reserve currency. You’ll also see why now may be the best time to buy gold for the rest of 2010.

But first we have to deal with the Fed. As you know by now, it raised the discount rate – the rate at which the Fed charges banks to borrow from it – by 25 basis points to a whopping 0.75%. Markets took this as a sign that the Fed is tightening monetary policy and beginning its ‘exit strategy’ from quantitative easing. The dollar rallied (more on that below).

Not so fast! The Fed made clear that it was raising the discount rate in order to encourage banks to borrow from one another and not the Fed. It wants the banks to play nice instead of doing business at the discount window. And it explicitly said it is not raising rates as part of a “tighter” monetary policy.

To be exact, the Fed statement read, “The modifications [to the discount rate] are not expected to lead to tighter financial conditions for households and businesses and do not signal any change in the outlook for the economy or for monetary policy.” Pretty clear there, isn’t it?

Of course the Fed could be saying one thing and meaning another. But what it says and what the market hears can be different anyway. And the market seems to think the Fed’s move supports the dollar. The bullish move in the dollar was crystallised by what traders call a “golden cross.” See below.

It’s a bit ironic a bullish move on the dollar index is called a “golden cross.” But what to the traders mean? A “golden cross” is when a 50-day moving average crosses up against a 200-day moving average, which is also on the way up. It’s doubly bullish, with an extra kick of momentum. But does the Fed’s small increase in the discount rate really account for this?

We’ll answer that in just one second. But when we asked Murray this morning whether the crossing of the 50 and 200 day moving averages was a big a deal as the headlines said, he said it wasn’t as useful indicator as the crossing of the 10-day and 35-day moving averages he uses. And then he sent us the chart below and told us that if the dollar index breaks through 79 (it’s at 80 as we speak), to look out for 84 as the next resistance.

On Murray’s chart, the blue line is the 10-day MA and the red line is the 35-day MA. The 84 level he mentions corresponds to the middle of the dollar indexes’ price distribution (the overlaid lines). This is exactly the same type of analysis Murray uses to generate trading ideas. And the dollar’s move is meaningful, given he has several long gold positions at the moment. We’ll let you know how those go.

But back to the key question: does the dollar’s strength come from the Fed’s move to raise the discount rate? Is this an “all clear” that worst of the crisis is behind us?

Definitely not. The dollar’s fundamental strength is not improved by a quarter point hike in the rate which the Fed charges banks to borrow. The annual fiscal deficit in the U.S. is in double digits as a percentage of GDP. The Congress is gridlocked. Many of the U.S. states are going bankrupt. And as Albert Edwards showed this week, the U.S. is insolvent.

None of those facts argue for a stronger dollar. But one thing DOES argue for a stronger dollar and that thing is this: the U.S. dollar is not the Euro.

In other words, the currency markets are telling us that the Euro’s ambitions as a global reserve currency may be dead. As an experiment in a managed currency designed to rival the dollar, it’s failed. Greece may be the proximate cause. But the design of the euro itself – one monetary policy to go with many fiscal policies (and fiscal deficits)- was the first cause.

As the main rival (amongst paper currencies) to the dollar as a global reserve currency, the euro’s coming collapse has to, almost by definition, equal dollar strength. There just aren’t that many more liquid alternatives for large institutions and central banks. They can diversify amongst higher yielding currencies and tangible assets. But the massive liquidity offered by short-term U.S. government debt markets is too easy to resist.

So everyone is piling into the dollar as a paper money lifeboat. The dollar’s inherited status as reserve currency has trumped (for now) the fiscal and monetary mismanagement of the U.S. political establishment. We think this makes now a very good time to buy gold.

Of course it might not see that way given that the gold price fell sixteen dollars in New York trading to $1,102. The superficially bearish news is that the IMF wants to complete the gold sale it announced last year by selling another 191 metric tonnes from its inventory.

Remember last year the IMF announced it would sell 403 metric tonnes of gold. The first 200 tonnes were sold, in a bit of surprise, to the Reserve Bank of India. The conventional wisdom had pegged China as the likely buyer.

Selling the remaining 191 tonnes would reduce the IMFs holdings by just one eighth. It would still be the third largest holder of gold reserves behind the United States and Germany. But is this bearish news for gold? Will there be any buyers? With the greenback rallying, will gold suffer from a supply dump on the open market via the IMF and a rampaging dollar index?

We’ll see. But we’d guess that gold’s going to be just fine. Just remember that all three buyers of the IMF’s last gold sale were central banks. The Central Bank of Mauritius bought two tonnes and the Central Bank of Sri Lanka bought ten tonnes. Central banks are still really the only institutions in the world that hold gold as a real monetary reserve.

Our guess – and we should make clear it’s just a guess – is that the IMF announcement will work out nicely for some central bank somewhere. The announcement will push the price of gold down temporarily, allowing a central bank to add to its gold reserves at a lower average price. But why would central banks be loading up on gold?

Well, if they’re unloading the euro and, in China at least, the U.S. dollar, they have to load up on something more tangible. So perhaps someone is twisting the IMF’s arm to sell more of its gold so certain sovereign nations are in a better position to survive in the event of sovereign debt default by one or several European States.

But we’ll make it simple for you. We’re headed back to the States next week for a quick trip and our intention is to sell the dollar on strength and buy gold. We’ll tell you how later.

For the moment, none of this major deck-chair scrambling in the global currency markets is affecting Aussie stocks prices. The indexes are up as we right. Reserve Bank Governor Glenn Stevens repeated the view, although these weren’t his exact words, that Australia has decoupled from America in the sense that future earnings and economic growth will come from trade with Asia.

That may be true, although we have our doubts. But the other question is whether Australia’s financial markets have decoupled from instability and volatility that originate in Europe and America. We suspect they haven’t. And for that reason, watch out. It’s going to be a crazy year.

Dan Denning
for The Daily Reckoning Australia

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The task of today’s Daily Reckoning is simple: ignore the largely irrelevant earnings news driving short-term stock prices and try to determine is the entire market is about to get smashed by another round of deleveraging in the financial system. This would result in another collapse in bank collateral, tighter Australian credit, slower economic growth, and falling equity and house prices (plus rising interest rates).

But before we make the conclusion, we should make the case. There is an Australian grouping of evidence. And there is an American grouping of evidence. Let’s deal with American evidence first. And let us call to the stand Reserve Bank of Australia assistant Governor Guy Debelle.

“While most of the recent jitters have been associated with sovereign concerns,” Mr. Debelle said in a recent speech, “I think the risks stemming from the financial sector are still there. A significant risk is that that we are still yet to see the full impact of the weakness in the North Atlantic economies on the loans on the books of financial institutions.

It might seem strange to begin the case for a further write down in bank collateral with an Australian central banker. But the good Mr. Debelle has done our work for us. He told a crowd in Sydney that, “We are now into the phase where weakness in the global macro-economy is feeding back into the financial sector…We are not all that far advanced in the adverse cycle that normally accompanies recessions.”

In other words, if we understand those comments correctly, there are more losses to come. It’s not just sovereign nations that are feeling the weight of bad debts. It’s the banks themselves – even after a year of recapitalisation and profit growth thanks to low interest rates – that could face serious trouble from a second of losses on residential and commercial real estate.

“For the North Atlantic economies,” Debelle concludes, “this was a big recession which, combined with large falls in both commercial and housing property prices, should result in large losses.” He goes on to point out that the government-guaranteed larger lenders might survive these larger losses. But smaller regional banks might not.

If those regional American banks fail you can expect two results. First, a larger burden the Federal Deposit Insurance Corporation (FDIC), the U.S. (underfunded) entity that insures bank depositors against just this sort of thing (up to US$100,000 per account). The other result would be a second-cousin of what happened when the Fed raised interest rates in the Great Depression: a contraction in credit.

Banks are the engine of money creation in the modern economy. If you have fewer banks, you have fewer engines of credit creation. Meanwhile, national assets and liabilities get concentrated on fewer and fewer but larger and larger balance sheets. It’s the collectivisation of finance, which in corporatist style, greatly benefits Wall Street money centre banks.

And this is all at the private and corporate level. In the world of public finances, American deficits are already spiralling out of control. The Federal Reserve, through its System Open Market Account, is taking an increasingly active role in supporting U.S. bond auctions. This is a fancy way of saying that as foreign investors refuse to finance U.S. deficits, the Fed must print money to paper over the gap itself. More details on this operation tomorrow.

Today, let’s ask the direct question: so what?

Why should Australians care if the United States has begun to monetises its debts? Well, it’s not certain, but you we’re pretty sure that U.S. monetary and fiscal policy is going to give rise to inflation, and higher interest rates. It will make credit harder to come by globally, just as it did in 2008 when the investment banks blew up.

This is bad news for Australia on two fronts. At the banking level, something terrible has happened since 2008. Bank collateral has not, in our opinion, materially improved. On the one hand, it still consists of huge chunks of U.S. commercial and residential real estate. Collateral damage!

On the other hand, those same U.S. banks have loaded up on another kind of equally toxic collateral. They replaced something bad with something equally bad, but perhaps less putrid (sovereign debt). U.S. banks, then, face a double collateral whammy this year from falling house prices and falling U.S. government debt prices.

Even if Australian banks don’t own U.S. backed real estate (and some do, mind you) and even if Australian financial institutions are not direct holders of U.S. sovereign debt (and some no doubt are), they’re still directly exposed to a world of tighter credit. And that world would be an accomplished fact if U.S. banks either ceased to exist or, as a result of more credit write downs, stopped lending globally.

The prosecution for another massive financial deleveraging in America rests. But what about our promised Australian evidence? Won’t things just be fine here, especially since China’s savers are set to become Australia’s creditors?

Well, maybe not. A speech today by RBA Assistant Governor Phil Lowe shows that Australia faces a similar collapse in private demand as in America. In turn, business investment is falling. Government is trying to fill the breach with a larger fiscal deficit. The end result may be economic stagnation and higher public debts and interest rates.

This all goes against the grain of the positive, earnings-driven news about the economy. But remember, the modern economy runs on huge supplies of credit to consumers and businesses. Take away that credit and you take away the fuel of GDP growth. Not even government intervention can offset the massive write downs in asset values required to put the economy on a sounder footing.

But how about the visual evidence. Mr Lowe provides the first chart below which shows falling private demand in the U.S., Europe, and Japan. This doesn’t include Australia. But we’d expect Australia to follow these trends if global credit becomes scarcer and asset values fall. Households and businesses will retreat into a more conservative cocoon.

Speaking of cocoons, Lowe’s next chart shows’s a figure specific to Australia: business credit growth. It’s fallen over 7% in the last year. Whether it’s because demand for credit is down or because supply is down (the willingness of bank’s to lend) is a relevant question. But the chart itself suggests another credit contraction, leading to more shockwaves in financial markets.

This slump in business credit growth has not yet affected access to capital for Aussie companies. Well, it has for companies on the margin of the mining business. But many other companies have turned away from the debt market (only the big banks got government guarantees to borrow). Instead, Aussie firms have tapped the equity markets. The chart below shows that listed companies raised over $85 billion in new share sales last year alone.

With a steady flow of compulsory super annuation money into the system, you could argue that Australian firms are going to have access to equity capital no matter how tight credit gets globally. And that might be true to a certain extent. But even assuming capital is available to listed companies, how will Austrlian firms grow profits in a world smothered by another credit crunch?

Quite clearly, they won’t. That, anyway, is the case for how a second round of deleveraging – driving by credit writedowns at American banks – will crush the Aussie market rally. There is, though, one saving grace. Maybe.

That saving grace is that if the sovereign debt risk in America supersedes the banking story, you will see an outright U.S. dollar crisis this year. That ought to benefit higher-yielding currencies like the Aussie dollar, although truth be told no one really knows how other paper currencies would fare in a full-blown dollar crisis.

What we do suspect is that the dollar crisis will be inflationary in nature. The monetisation of U.S. debts (public or private) will lead to a weaker dollar. And all things being equal, that ought to lead to much higher precious metals and oil prices.

Whether than translates into higher prices for precious metals and energy shares is also an open question. Do you want to be in the equity markets during another round of deleveraging? Last time around, resource stocks proved no refuge at all. And commodities themselves were as inflated as anything else. This time around, what is the best refuge?

Dan Denning
for The Daily Reckoning Australia

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Finally, some reader mail.

Dear Dan,

I am replying to your email referring to the communications minister as “Comrade Conroy”. It saddens me to hear people using COLD WAR terminology to refer to anyone that they don’t agree with.

At the same time you used the term of endearment “poor old” Barnaby Joyce for a politician that most people in Australia would consider a nutcase (irrespective of their political persuasion).

It would be much nicer for all (especially for those of us who read your (economics) newsletter ) if you could refrain from using emotive language which does not have any place in such a publication.

Best leave it to the CRAZY – Right Wing mouthpieces of the Conservative movement rather than from someone who is supposedly an enlightened , modern, economics, commentator.

Regards,

Peter K.

Thanks for your note Peter. We called Minister Conroy a “Comrade” because he backs a policy of paternal authoritarianism in Australian public life, not because we simply disagree with him. You should call things by their right names. It makes arguments a lot more honest.

Sorry to make you sad. But a lot of we write makes people sad, apparently. And we don’t really care what “most people” think about Barnaby Joyce. By the way, how do you know what “most people” think? We were telling you what we think. That’s all.

Finally, are you really in the position to decide what’s “nicer for all?” Even if you were, we’d be inclined to do the exact opposite anyway, just on principle. Our mission here isn’t to make people feel better. It’s to make people think, even if they are offended by the ideas we have. If that makes us unenlightened, we’re happy to stay in the dark.

Dan Denning
for The Daily Reckoning Australia

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What a difference a day does not really make. The back-story to the markets – the slow-motion insolvency of the Welfare States – was ignored by rested U.S. investors yesterday. They came back to the floor and bought stocks like it was old times.

Both the S&P 500 and the Dow Jones Industrials finished up over 1.5%. There were two drivers of the feel good vibe. First was New York’s Empire Manufacturing Survey. It concluded that “conditions” were improving.

As far as we can tell, that doesn’t mean anyone actually made and sold more stuff in New York State. But it does mean the state of mind – how people feel about things – appeared to improve. Hooray! It’s nice people feel better about things. But things are still pretty bad anyway.

The bigger story is that Greece hasn’t been abandoned by the rest of Europe…yet. Europe could probably leave Greece behind and preserve the integrity (such as it is) of the euro as a sound currency. But 50 years of harping on about social justice and economic harmony and humane capitalism is going to make it hard for policymakers to leave Greece to its own devices.

This means the debt crisis is consolidating itself into ever fewer and larger entities…the European Union…the U.S. government…and the U.K. government to name a few. In order to save Greece, historians may write, it was necessary to destroy the Euro.

But investors don’t have time machines. In the modern era of central banking, new lines of credit and public assumption of large liabilities – plus more credit creation – has always been the way out of a pinch. Below, we’ll tell you why this makes the inevitable disaster that much worse.

Here in Australia, it looks like the financial crisis is receding. We have our doubts. But according to Gail Kelly and the good people at Westpac, bad debts were down even more than expected in the first quarter. That’s the good news. The bad news is that, “the average cost of funding is going up.”

The strategic weakness of the Australian banking sector – and perhaps the whole economy – is that it’s a capital importer. That’s why even when Aussie banks didn’t have boatloads of U.S. subprime debt; they still faced higher capital costs when the global cost of capital went up. So what?

If Greece goes down or sovereign debt default spreads go up, it’s going to make importing money into Australia more expensive. And that will probably slow credit growth in the economy. Aussie banks will get jealous of their capital and stingier with their lending. Maybe even house prices – contrary to the laws of Australian financial gravity – will fall.

And if you think that’s gloomy, then you won’t want to read what Albert Edwards from Societe Generale has to say about the status quo. Writing earlier this week, Edwards says, “My own view on this is that obviously we should never have got into this wholly avoidable mess in the first place. But having got here, there really is no way out that does not trigger a major market-moving upheaval.“

“Ultimately economic prosperity over the past decade has been a sham: a totally unsustainable Ponzi scheme built on a mountain of private sector debt. GDP has simply been brought forward from the future and now it’s payback time. The trouble is that, as the private sector debt unwinds, there is no political appetite to allow GDP to decline to its ‘correct’ level as this would involve a depression. So burgeoning public sector deficits and Quantitative Easing are required to maintain the fig-leaf of continued prosperity.”

This what we meant above about the inevitability of the disaster that approaches. When the government “brings forward” demand for housing via the FHOG or for consumer goods via stimulus, it’s stealing growth from the future in order to maintain current living standards. In our view, this just perpetuates the misallocation of resources that took place in the credit boom and keeps the money in the weak hands (the financial sector) that took so many bad risks in the first place.

A real free market punishes financial failure with bankruptcy or insolvency. By not allowing a recession to take its natural course, monetary and fiscal policy prevent the conditions for the next growth phase. What’s worse, they’re doubling down on the debt-backed model of prosperity and piling up more liabilities on the public sector balance sheet.

That’s the stage we’re at now. And one insignificant survey on manufacturing sentiment in New York State doesn’t change much. And by the way, the more important news yesterday is that demand for U.S. bonds by foreign investors fell by its largest amount ever. Strong dollar?

Foreign holdings of U.S. Treasury securities fell by $53 billion December. China reduced its holdings by $34.2 billion. The end game is beginning in the Chimerica relationship of vendor financing (China buys U.S. bonds to help keep U.S. rates low so Americans can buy what China makes).

What China doesn’t buy, you can get the Fed will have to monetise – unless the Congress and the President suddenly cut American spending. You can see from the chart below that Japan is now a larger holder of long-term U.S. securities than China.

The long-term trade on this is to get the heck out of U.S. assets. Whether “risk assets” like commodity currencies or commodities are the ultimate refuge is yet to be seen. But oil, gold, and resource stocks are certainly getting a big today on greenback weakness.

Dan Denning
for The Daily Reckoning Australia

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Is that a deep sense of foreboding you feel as well, dear reader? It could be we just have a bad case of the Mondays. But today’s Daily Reckoning will try to do the impossible: look just over the economic and geopolitical horizon. We’ll tell you what we see and what investors should do about it.

First though, why panic? Stocks finished up for the week for the first time in a month last week. And it’s earnings season. On the S&P 500, 377 companies have reported earnings from the December quarter. Of them, 277 beat analyst estimates while 67 missed.

Here in Australia it’s a huge week for earnings. BlueScope Steel reports today. Tomorrow, you have Foster’s. On Wednesday, Coca-Cola Amatil and CSL. Thursday is a biggie with Lihir, Qantas, Santos, and Wesfarmers. And Friday, Andrew Forrest and Fortescue Metals Group tell us how the iron ore business is.

Come to think of it, the iron ore business is a good case study for today’s conversation. Earnings are backward looking. What we all want to know is how business is going to be this year and whether stocks are already priced for any of that future earnings growth. So what’s the story?

The rumours making the rounds are that Chinese steel mills – rather bitterly – have accepted a 40% increase on last year’s contract iron ore price average of $60. Even at $84, though, the contract price would be well below the current spot price. That’s closer to $130.

Fortescue is Australia’s third-largest ore producer. Naturally, higher contract prices and an elevated spot price would be good news for it and all the other aspiring ore producers in the West. This is why Diggers and Drillers editor Alex Cowie is set to recommend two new would-be ore producers (hopefully after the market closes today).

His number one recommendation does well as long as contract prices are above $41. The company has a cash cost of production of $31 per tonne, plus another $10 to amortise the capacity expenditures (although these depend on the final figures to be released in an upcoming Bankable Feasibility Study).

All that makes sense to us, and is an excellent punt on higher ore prices. But as a contrarian, we also wonder if ore prices are peaking out now just as they did in 2007. We hope we’re wrong. But two news items published over the weekend gave us the heeby jeebies. Both could be increasingly bearish for resource stocks.

The first is that China’s banking authorities increased reserve ratios at banks to 16.5%. It was a 50 basis point rise. According to Colleen Ryan at the AFR, it removes US$300 billion from the Chinese economy. But it scared world markets even more.

If China keeps raising reserve requirements to contain inflation, it could slow demand for credit by real estate speculators. That would slow commercial real estate and fixed asset investments. And that would slow demand for Australian iron ore (among other things).

If you read today’s papers you’ll see Chinese officials are worried about inflation (January producer prices were up 4.3% over December prices). But the International Monetary Fund (a policy tool of the Western Welfare states) is pushing for higher inflation targets. A new IMF paper says that cash hand outs to manage higher unemployment should be a standard part of monetary policy. But as these push up inflation, governments will have to tolerate just a bit more inflation than current targets allows. We’ll get back to this fraud in a moment.

With China, the authorities are quite rightly worried about inflation. And the biggest sign of inflation is the commercial property market where a massive bust is brewing. According to Jack Rodman – who makes his living selling bad real estate loans – there are 55 empty office buildings in Beijing with another 12 on the way.

Figures suggest that the vacancy rate in Beijing real estate is 22.4%–meaning nearly one of every four office buildings is empty. In the CBD, it’s an even higher 35%. And this year, another 1.2 million square metres of new space will be added to the 9.2 million square meters that already exist.

Now you know where all that iron ore is going. And now you know why Australia’s resource earnings could be in jeopardy if the Chinese real estate bubble pops. Of course you might argue it’s not a bubble. It’s just the rest of the world wanting to hang out its corporate shingle in what will be the biggest economy in the world over the next 100 years.

Maybe. But in January alone, Chinese banks loaned $203 billion dollars. That was more than the previous three months combined and 20% of the annual target. The government will try and slow down the lending boom over the Chinese New Year. But we’d be very worried that the Chinese lending boom has already driven up some commodities two and three times from their 2008 lows – and that a severe correction could be on its way (soon).

And here you thought Greece defaulting on its sovereign debt was the big story. Granted, that IS a big story. Harvard University Professor Martin Feldstein says the current crisis exposes the major flaw in the Euro’s design. “In Europe, they have a single monetary policy and yet every country can set its own fiscal and tax policy.”

Now, you have the Germans telling the Greeks to suck it up and live within their means. We’ll see how that goes. Remember, the last two World Wars started in Europe. These people know how to violently disagree. Not even 50 years of feel-good trans-national progressive thought can quench the natural differences of language and culture.

But what you see from the IMF’s move toward higher inflation targets and from the higher debt-to-GDP ratios across the globe (or more state intervention in the economy a la China) is what we think is a high water mark in the hubris of the “multi-national nation state.” These are large, artificial political and economic unions that are torn in different directions by the economic imperatives of globalisation (outsourcing, lower wages, cross-border integration) and the political realities of globalisation (lower wages at a time of ageing populations that demand more services and money from the State).

Granted, the Greek crisis may not infect the globe the way the subprime crisis did. Larry Kantor of Barclay’s says most of the $200 billion in at-risk sovereign debt from Greece, Spain, and Portugal is held by Europeans. Thanks to AIG and Goldman Sachs, Wall Street managed to distribute $1.5 trillion of its high-risk, high-yield subprime backed crack across the globe (what Alan Greenspan has called the dis-aggregation of risk…which roughly translates…eat that suckers!)

But will Greece take the Euro with it? And are Europe’s currency and debt problems the leading edge of the larger problem with Japan, the U.S. and Europe: they have lost economic competitiveness to the developing world (Brazil, China, and Russia) but insist on a social living standard that you can only afford if you have a productive economy generating surplus wealth.

Keynesians mistake growth with wealth. More government money taken out of the private sector and given away as stimulus promotes a kind of growth. But it is activity without the purpose of profit. Socialists will tell you that’s that good. We’d argue it’s a misallocation of resources (land, labour, capital, and commodities).

The trouble is that in reaction to the high-profile of leveraged finance, governments are increasing their take of private wealth. In the U.K., for example, the cash-strapped government wants a 3.5% hike in the value added tax to a European standard 20%. This will presumably keep the government solvent for a little while, spreading the wealth around as long as people bother trying to generate it.

But increasing taxes without reducing spending does nothing to increase productivity or prosperity. It just takes money out of productive hands and puts into the hands of preferred political constituencies. Yet when you produce nothing of value in the market place, you have to scour for revenues wherever you can.

Here in Australia, the Business Council of Australia has called for lower government spending. But you might have missed the fact that it also called for the retirement age to be raised to 73 by 2049. The Council says that by 2049, the number of Australians 65 or older will grow from 2.9 million today to 7.4 million.

The best way to deal with that – from the government’s perspective – is to raise the retirement age so you can’t begin drawing your old age pension till later-preferably not before you die. This keeps you paying into the system longer without drawing any benefits. That should keep it sound, for awhile.

Or not. By our reckoning, you’ll see more and more people choosing to retire now. That is, you’ll see people chose to liquidate their financial assets and convert into more tangible wealth beyond the reach of the tax man (when it’s possible and legal). And you’ll see the collapse of the most artificial creature of the last 200 years, the multi-national nation state. More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

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