For the past 60 years, corporate debt has grown faster than the economy - 4.1% annually for debt, compared with only 2.7% for the economy as a whole. In short, more and more debt went toward producing each dollar of GDP growth.

What if this 60-year trend reverses?

In fact, I think that is the likely scenario. The deleveraging will take some time...and it won't be fun.

"Today's overleveraged assets will become tomorrow's underleveraged assets, and vice versa," QB Partners, a hedge fund, explained in a recent letter to shareholders.

What will this new world look like? More people will save more money. And they will focus more on preserving that wealth than on making a big score. We've been here before. Michael Farrell, the chairman of Annaly, says the psychology of people will change as it did for those of 1930s, as he discussed on his company's first-quarter conference call:

Exhausted by the uncertainties of the 1930s and 1940s, the older generation just felt lucky to be alive and they settled into a time of saving, preservation of capital and lowered expectations as consumers.

If that kind of financial orthodoxy takes root, then leveraged assets like real estate and bank balance sheets face a long period of stagnant returns as they continue to deliver - that is, as borrowers and lenders ratchet down the debt on these things. (I find it ridiculous that government officials want us to believe that the US banking system is OK at 25-to-1 leverage. The banking system's insolvency will become more apparent as it continues to take losses from bad debts made during the bubble.)

Deleveraging puts pricing pressure on leveraged assets. Banks must raise capital, diluting their shareholders and hurting their stock prices. Real estate owners must sell property to raise capital to defend other properties, thus putting pricing pressures on real estate assets. And so on...

So as an investor, it will pay better to stick with the unlevered assets, which face no such head winds. After all, there is no pressure to sell an asset with no debt, no ticking clock. "What are the most underleveraged assets?" you ask. QB Partners gives the answer: hard assets and natural resources.

The ultimate unlevered hard asset may be humble old gold.

In fact, something important is happening in the gold markets right now. All through the 1990s to the present day, the world's central banks were net sellers of gold. Europe's central banks, for instance, have sold 3,800 tonnes of gold in the last 10 years. According to The Financial Times, this move has cost them $40 billion, and that's with gold at $900 an ounce.

Well, too bad for them. But suddenly, that recent habit of selling gold is changing. Last year, central banks sold only 46 tonnes, which was the lowest amount in 10 years.

As the FT reports: "Sales in Europe have slowed to a crawl and fresh demand is emerging elsewhere and the financial crisis has helped to highlight gold's value in turbulent times." In fact, we may soon see central banks flip to net buyers of gold.

China has doubled its holdings of gold this year and is now the world's fifth largest holder of the metal. China is likely to be a buyer of gold for years because its gold holdings are still very small relative to the size of its total reserves. Gold represents only 1.6% of China's reserves, versus a global average of nearly 11%. To further diversify its reserves - just to get to average - would require significant amounts of gold.

In a post-2008, deleveraging world, it is the unleveraged assets that will outperform against those saddled with debt. It's another plank in the case for gold, which just seems to get stronger with each passing month. "A new chapter has begun in the gold market," the FT opines. Indeed, it has.

The International Monetary Fund, never known as a wise handler of money, is selling a bunch of gold. India bought half of it. A number of emerging market central banks are also upping their gold exposure. Maybe these CBs are onto something.

Russia's gold holdings now make up 4% of its foreign reserves, compared with only 2.2% at the beginning of the year. Smaller central banks are also being crafty. Ecuador's gold holdings have more than doubled since the start of the year - to 54.7 tons, from only 26.3 tons. Gold now represents 32% of that country's reserves. Even Venezuela is buying gold. Gold now makes up 36% of its reserves, compared with only 23% in 2009.

So who is the sucker here?

Perhaps central bankers see more clearly than most what the effect of all their money creation will be. In recent months, we've seen a truly unprecedented boom in bank reserves. Bank reserves drive money creation. More money means money buys less - and the gold price should rise.

Then there is this chart of the Shadow Gold Price. In the old days of the Bretton Woods Agreement, countries had to maintain certain ratios of gold against their currencies. The Shadow Gold Price aims to replicate this discipline. So for the US, the Shadow Gold Price is Federal Reserve Bank liabilities (bank reserves) plus money in circulation divided by US gold holdings. Also on the chart, you can see the spot price of gold.

The important thing here is that you see how massive amounts of money creation have barely made an impact at all in the gold price - so far. Gold is fundamentally cheap compared with all the money added to the system in recent months.

As Paul Brodsky and Lee Quaintance of the hedge fund QB Partners write:

"If one allows for even a small probability of a future monetary system that reflects more honest/tangible money, then a quick glance at the graph above makes it easy to conclude that spot gold is fundamentally cheap. Even if this is too far a stretch for market participants skeptical of such a radical change in monetary policy, it is reasonable to conclude that the prices of spot gold and the Shadow Gold Price should converge somewhat over time."

They note that the spot gold price has never been so cheap compared with the Shadow Gold Price. For parity to set in, gold would have to trade for $16,000 per ounce! No one is predicting $16,000 per ounce gold. In any case, it shows you the risk of holding paper - and bonds - on the eve of a massive devaluation of the dollar. Maybe the central bankers of Russia, Venezuela and Ecuador understand all of this better than they let on and that's why they are buyers of gold.

It seems pretty obvious to me that if you create a lot of money, you are going to destroy the value of that money. And in that case, you want to own something other than that money.

Regards,

Chris Mayer
for The Daily Reckoning Australia

• India Beats China to Walk Away With 200 Tonnes of IMF Gold
• IMF Deems Gold An Idle Asset
• Stock Prices Down Signals Bears to Hold onto Cash, Treasuries and Gold
• Gold Bought by Some of America’s Most Successful Investors
• Fed Trying to Push Private Investors into Riskier Asset Classes

You editor is visiting his son and grandson in Buenos Aires. Last night, granddad agreed to babysit so the young parents could go out to dinner.

After a pizza and some horsing around, the little boy - 18 months old - began to have doubts about granddad. It was late. He was getting tired. He looked around and asked for "mama."

No stranger to parenting, your editor knew just what to do. He put the boy in a stroller, took him out on the street, and began a long walk.

We were in Palermo Soho, a thriving and trendy neighborhood of Buenos Aires. The buildings are only two or three stories high. Streets are made of cobblestones, with sycamore trees on each side. And everywhere you look, there are restaurants, cafes and boutique shops. By day, it is a nice area...but a visitor sees derelict buildings as well as spiffy renovated ones. At night, the run down properties disappear in the shadows.

In the Plaza Serano, a man on stilts walked the streets. He must have been looking for tips from the automobiles that passed. Little Liam, our grandson, looked up at him in alarm. The world must be a strange and wonderful place to a small child; he must have wondered how the man got so tall. In the center of the square, a small woman sang tango songs, accompanied by a guitarist and an accordion player.

We walked along. People looked at Liam in his stroller and smiled. He smiled back. Then, they looked at your editor with curiosity, wondering if he was the father or the grandfather. Couples walked arm in arm. Some embraced on street corners. One couple sat on a bench, kissing on each other so enthusiastically they clearly needed a hotel room. Several cafes had tables out on the sidewalks. Waiters carried trays of beer and wine. Girls in blue jeans looked at the fashions in a shop.

Within two blocks, Liam was fast asleep. The jostling of the paving stones didn't seem to bother him. Neither did the wail of an ambulance or the murmur of couples in conversation. Or the bright lights of the restaurants.

But by then, we were fascinated. There were so many young people on the street. So many fashionable shops. So many renovated houses, many with innovative and interesting designs. So many bars. So many cafes and restaurants...each with its own theme. One promised a traditional 'parrilla"...another advertised 'Italian cooking'...still another was clocked in red, promising diners an amorous encounter.

We wandered for blocks. Then we realized we were lost. No matter. We just kept walking...looking in the restaurants...studying the shoes and dresses in the shop windows... and smiling at the passers-by.

There are many cities with lively sections. Many offer interesting nightlife. But we can't recall one where the nightlife seemed so relaxed and friendly that we could walk along with an infant in a stroller and have such a good time. Maybe it's because we never tried.

Regards,

Bill Bonner
for The Daily Reckoning Australia

• Why Not Move to Buenos Aires?
• Republican Candidate’s 17-Year-Old Daughter is Pregnant
• Unexpected Visitor at the Chateau in Ouzilly
• Normally Small Businesses Lead the Economy Out of Recession
• The Rising Price of Oil Has Done Less Damage in Europe Than in America

Can anything stop stocks and gold?

Trees do not grow to the sky, dear reader. And for every bounce there is a bust.

"It's amazing; the US is doing everything that Japan did wrong," said a friend yesterday.

Let's see, in the 1980s Japan's corporate leaders thought they were going to take over the world. Investors thought so too. They expanded. They wheeled. They dealed. Prices shot up and they all thought they were geniuses.

In the '80s, everyone wanted to be Japanese. Management consultants used Japanese words to describe commonplace insights. For example, instead of saying that businesses always need to try to do things better, they referred to "kaizen" as if it were the secret of success. And US economists urged the Reagan Administration to have an "industrial policy" - because that was what Japan had. Japanese businesses were the envy of the world. Japan was the world's second largest economy. But in growth and stock prices it was Numero Uno.

It turned out, as it always does, that Japan did not have the secret to everlasting success. Instead, what it had was what comes before a fall. The stock market crashed in Tokyo in 1989. The Japanese economy entered a recession. At first, the experts believed it was temporary. They urged investors to take advantage of the opportunity to buy into Japan, Inc. at record low prices. They thought Japanese industry was unstoppable...unbeatable. It would recover in no time, they said.

But Japan, Inc. didn't recover. Instead, it went into a long, drawn-out recession that lasted year after year...with on-again, off again deflation...and several stock market rallies. Each time stocks rallied, they fell again. Each time the economy began to grow...along came another setback. This continued for the next 20 years...until March of this year...when Tokyo stocks hit their lowest point for the whole bear market. A generation of investors had been nearly wiped out. Over two generations they had made nothing. Trillions worth of wealth had been erased.

What did the Japanese authorities do during these last two decades? They fought the correction every step of the way, with the boldest attempt at fiscal and monetary stimulus every undertaken up to that point. Interest rates came down to effectively zero. And government spending soared, creating the largest deficits in Japanese history. Now, Japan's national debt approaches 200% of GDP - a peacetime record. If it continues to grow at this rate, it will hit 300% of GDP in just a few more years.

Sound familiar? It should. The key US interest rate is now effectively zero. The Fed says it will leave it there for "as long as it takes." And deficits have reached staggering levels - 13% of GDP. At this rate, the US debt/GDP ratio will hit 100% in just a few years. And if it continues, US debt/GDP will reach 200% not long after - as recession- reduced tax revenues meet stimulus-increased outlays.

But wait...the feds say they won't let it happen. They'll turn this thing around. The economy will begin to grow. Tax revenues will rise. Prices will go up.

Hey...that's just what the Japanese said!

So far, the US is doing almost exactly what the Japanese did...propping up zombie companies and stimulating the economy as best it can.

But if it does the same thing the Japanese did, won't the US get the same results the Japanese got?

Here is where it gets interesting. Because the US economy is not exactly like the Japanese economy. Japan had high savings...and a positive trade balance. It could run up huge government debts and "owe it to itself." It could finance its government debts with the savings of its own people, in other words. It never had to worry about foreigners refusing to buy its bonds...or selling them suddenly.

America's government debt is different. The US doesn't save enough to finance its own deficits. So it depends on the kindness of strangers. And if those strangers ever lose faith in America's ability or willingness to repay its debts, they'll drop the dollar like an annoying girlfriend. And when they do, the whole global monetary system will come crashing down.

But suppose savings rates go up in America - to, say, 10% of GDP, like they were before the bubble years. That would make $1.4 trillion of savings available to finance the feds' deficits. And suppose the slump continues...as we think it will, with another big scare in the investment markets. People will seek safety in...yes, you guessed it...US bonds. This will take the pressure off the dollar and permit the US to finance its countercyclical spending without depending heavily on foreigners. The recession/depression will be annoying...but not insufferable. And Bernanke will figure he has more to lose by undermining the dollar than to gain from it. In that case, the Japan- like slump could go on for many years - just as it has in Japan!

Bill Bonner
for The Daily Reckoning Australia

• Japan “Wasted Trillions” on Stimulus Programs
• Recession for the Japanese Economy Once Again
• Difference Between the Dollar and the Yen
• How Will the United States Finance the Biggest Deficit of All Time?
• U.S. Government Must Roll Over $3.4 Trillion in Debt Over Next Four Years

Then on Tuesday the market snapped up $25 billion in ten-year notes and yields fell. Sovereign debt? Big whoop! Whether it's the end of the year and investors feel safer in Treasuries, or some other reason, Tuesday's auction showed no signs of an impending "bond fire of the vanities." The bond bubble keeps getting bigger.

Today, though, the market gagged. In an effort to lock-in low rates for longer terms, the Treasury served up $16 billion in 30-year bonds. The market turned sour. Reuter's reports that demand for the 30-year was the weakest since May and that yields moved up as the weak auction triggered selling.

And then everyone seemed to lose their nerve. Stocks fell across the board. Gold set a new high at $1,123.40 in New York trading, before retreating. The weak 30-year auction has people thinking...what happens when Treasury supply overwhelms demand?

What will happen to bond prices then? To inflation? What should I do?

The rest of today's Daily Reckoning will be devoted to some constructive apocalysm. We may have left the impression yesterday that there was nothing but pain and heartache ahead for investors. But that doesn't have to be the case. But you have to start with the big picture. And that begins with the end of the bull market in bonds.

Check out the chart below from Ron Greiss at the www.thechartstore.com. Ron's chart shows long-term U.S. bond yields since 1941. Mostly this reflects the yield on 30-year bonds, although there were periods where 30-year issuance was discontinued. Either way, it shows a great cycle...which appears to be bottoming out.

What story does this chart tell? We reckon it shows you why the U.S. government (and so many banks and borrowers) are eager to sell as much debt now as possible. Rates are near historic lows. If and when they go up, it's going to make borrowing and servicing new debt even more expensive. Bond prices will fall and yields will rise again.

Now you could say that, according to the chart, there is room for another decade of low yields. The Fed, for example, could move to set rates further out on the yield-curve. It only sets rates right now for short-term debt. But the quantitative easing program has moved the Fed out to ten-year yields. It's done this to try and keep mortgage rates low, as mortgage-rates are keyed to U.S. ten-year yields.

But we reckon not even the Fed can keep yields low forever by supporting prices. It will have to wind down its programs eventually. For example, the U.S. government ran its largest October deficit ever last month, at $176 billion. Between demographics and existing debt, the Fed may not have the resources to support bond prices too.

Besides, you'd think markets would begin to tire of U.S. debt, given the lousy fiscal position of the American government. At least that's what we'd think. And if we were trading it, we'd look for put options on ETFs that track bond prices, or call options on ETFs that track bond yields. That would be the cheap trade.

The investment decision is to find assets that out run inflation as bond yields move up. Granted, this assumes there is going to be inflation, which is a whole other argument. But if you'll grant us the assumption, we'll continue with the strategy...of finding assets that beat inflation.

You don't have to look far. Gold...oil...iron ore...tangible assets are what you're after. Does this conflict a bit with our analysis yesterday that China's resource demand is more fragile than reported? Yes, it does. But it still pays to focus on those resources that will be in demand no matter how bad the global economy gets again. What do nation states really want to own? What can they not do without?

You know they can't do without oil. And you know more and more of them prefer to own at least some gold rather than rapidly devaluing foreign currencies. That leaves us where we began, buying oil and gold and selling U.S. sovereign debt. Production of the first two is hard to increase. Supply of the last one is growing.

"There is a strong case to be made that we are already at 'peak gold'," Barrick's Aaron Regent told London's The Daily Telegraph today. Regent was speaking at RBC's annual gold conference in London. "Production peaked around 2000 and it has been in decline ever since, and we forecast that decline to continue. It is increasingly difficult to find ore."

Gold exploration budgets are up. But with the exception of China, gold production from traditional stalwarts like South Africa and Australia has trended down. Alex Cowie at Diggers and Drillers recently wrote a report suggesting that the best Aussie gold stories are listed here in Australia but digging for gold in Africa, where they incur production costs in U.S. dollars and where there are more greenfield projects than recycled brownfield projects.

Frankly, we have no idea if gold production has peaked. Mine supply could grow this year for all we know. But finding and mining gold is not easy and it's not cheap. And even if the gold supply does grow, we'd take it to the bank that the global gold supply will not grow faster than global money supply.

And oil? Any scenario in which an economic collapse leads to falling GDP ought to mean lower demand for oil and lower oil prices. But the case for oil is not really about the demand side. You reckon that's bound to grow over time anyway, unless someone comes up with table top cold fusion. The real oil bull story is on the supply side.

Earlier this week the U.K.'s Guardian reported that, "The world is much closer to running out of oil than official estimates admit, according to a whistleblower at the International Energy Agency who claims it has been deliberately underplaying a looming shortage for fear of triggering panic buying."

" 'The IEA in 2005 was predicting oil supplies could rise as high as 120m barrels a day by 2030 although it was forced to reduce this gradually to 116m and then 105m last year,' said the IEA source, who was unwilling to be identified for fear of reprisals inside the industry. 'The 120m figure always was nonsense but even today's number is much higher than can be justified and the IEA knows this.'"

We remember writing about the IEA figure a few years ago. And we remember pointing out that producing 120 million barrels of oil per day would be a 44% increase on producing 83 million barrels per day. And you'd have to find that oil first. You'd have to explore, drill, and produce it. And you'd have to maintain existing production levels at the world's big elephant fields like Cantarell and Ghawar.

In point of fact, production at Cantarell has fallen by 25% since 2004. Energy expert Matthew Simmons says Mexico's days as an oil exporter will end in 18 to 36 months. This makes Mexico's government-which derives 40% of its revenues from oil sales-the most likely candidate for "next failed state."

By the way, if you think illegal immigration is problem in America now (and it is), imagine what would happen if the finances of the Mexican state imploded with a production catastrophe at Cantarell. The Obama administration would face another crisis, but this one right on its massive southern border.

Not everyone believes in Peak Oil. But it's not really a matter of faith. Either oil production is declining or it is not. It does not mean there isn't any oil left. In fact, technology has lengthened the life of productive fields. And technology has also made it possible to find and produce oil in increasingly hostile environments (deep water drilling, the Arctic, etc.)

Even rank and file petroleum geologists are mostly in agreement (and sometimes in disagreement with their corporate overlords) that Peak Oil is real and it's here now. But we make this point not to say that all is lost. It isn't. It's just the great changes in the world are afoot.

You have a secular bond bull that's long in the tooth. The post-war monetary system that supported the expansion of the fiscal welfare state through perpetual debt is failing. Energy, which has been getting cheaper and cheaper for years as we found more and more of it, may start becoming more expensive and harder to find.

That's going to make the world a slightly less friendly place. But for investors, there are heaps of opportunities. For example, right now Alex is looking at what the fallout from next month's Copenhagen summit is. It has opened the door to a great entry point for energy investments, but not necessarily oil. Fear not! Or fear a little. But prepare.

Dan Denning
for The Daily Reckoning Australia

• Attack of the Bond Yields
• Central Bankers Encourage Debt Booms That Become Debt Bombs
• U.S. Bond Prices Rose and Yields Fell
• Higher Oil Prices, the New Normal
• Choking on Debt in the Unfolding Anglo-Saxon Bond Crisis

There is a risk in holding cash in an environment of asset price inflation - a condition that usually occurs when governments create large fiscal deficits and inflate the money supply. The practice is endemic to banana republics and declining empires...and it is happening in the US at this very moment.

The global recession and financial crisis have refocused attention on government stimulus packages. These packages typically emphasize spending, predicated on the view that the expenditure 'multipliers' are greater than one - so that gross domestic product expands by more than government spending itself. Stimulus packages typically also feature tax reductions, designed partly to boost consumer demand (by raising disposable income) and partly to stimulate work effort, production and investment (by lowering rates).

The existing empirical evidence on the response of real gross domestic product to added government spending and tax changes is thin... But the evidence is quite strong that these policy responses usually trigger inflation.

I suppose that even someone without any common sense might understand that a "strong currency" over longer periods of time reflects a high degree of prosperity and economic success, whereas a chronically weak currency is symptomatic of economic imbalances, such as a lack of competitiveness or overconsumption, arising usually from excessive supply of money and credit.

I would also suppose that even if someone never travels overseas, he would understand that if the US dollar loses 50% of its value against all the other world currencies (everything else being equal), it means the US is 50% poorer relative to the rest of the world. (Now, this is not entirely correct, since the US has overseas assets that would appreciate in value in USD terms).

Moreover, stock price movements become extremely volatile and erratic in countries with a depreciating currency. In the long run, the depreciation of the currency will usually more than eliminate the gains in local currency terms. So, whereas in 2007 both the Dow Jones and the S&P 500 exceeded their previous highs reached in 2000 in US dollar terms, these indices failed to make new highs in Euro terms. In addition, whereas the US economy expanded in US dollar terms between 2001 and 2007, in Euro terms it actually contracted!

Even with the S&P 500 having shot up since the beginning of the year by over 25%, it has merely kept pace with the price of gold. And during the last 10 years, the S&P has lagged behind the official US inflation rate...while lagging VERY far behind both the euro and gold. Since the end of 1999, the S&P 500 has delivered a total return after inflation of about MINUS 25%.

Unfortunately, the US is not the only country that is busily debasing its currency. "Everyone" is doing it. Because of the current collective debasement of all paper currencies by central bankers, I believe that precious metals and mining companies will maintain their purchasing power.

In the 1980s the US dollar was a very strong paper currency compared to the Mexican Peso. Today, there is no paper currency that is as strong relative to the US dollar as the US dollar was relative to the Peso in the 1980s! The only "currencies" that have a chance of becoming as strong against the US dollar as the US dollar was against the Peso between 1979 and 1988 are precious metals such as gold, silver, platinum, and palladium.

Also, I should add that precious metals could appreciate even if the US dollar miraculously recovered strongly against foreign currencies for an extended period of time. Such dollar strength would probably be a symptom of some horrible economic or political problems around the world, which could be friendly to precious metals.

Central bankers and pundits seem to believe that they have averted the second Great Depression, while ignoring the fact that more and more debt produces less and less GDP and fewer and fewer jobs.

For now, though, the low ten-year bond yield is the lifeline from which all support flows. Much of the investment universe holds together because money can still be had for cheap - not by the volition of a cooperative private sector, rather induced by a US government that simply distributes money for free. Such an ill-conceived idea could only have been born in the test tube of a central banker.

Private lenders comprehend the difficulty of making profits when being forced to lend for nothing, so the government increasingly finds itself to be the interest-free lender of last resort.

Ultimately, if central bankers continue this process for long enough, it is the dollar, and any currency or economy still pegged to it, that could eventually crash. Therefore, we investors find ourselves in the precarious position of having to maintain sufficient liquidity, but not too much in case the real value of these liquid reserves is wiped out by politicians and central bankers gone mad.

Regards,

Dr. Marc Faber
for The Daily Reckoning Australia

• US Dollar As Reserve Currency Not Working Very Well
• 4 Ways to Protect Against a Falling Dollar
• Is Gold Money?
• Gold Falls for Four Straight Days but is the Low Price a Bad Thing?
• Transfer of Wealth

We did some thinking yesterday, on our trip to Uruguay. Why Uruguay? We thought we should have a look around. Montevideo is a cheap place to live. It's on the sea, with beaches near the downtown area. It is an old town, with many fine buildings. It is clean. It is safe. It has history too. When the English invaded Buenos Aires, the Spaniards launched a counterattack from the fortress at Montevideo and got it back.

"It looks like a nice place," we said to our local contact. "But it seems a little like a resort town out of season; it's very quiet."

We were having dinner in the best restaurant in town, next to the opera house. The restaurant was large and well fitted out. But it was almost empty. A French group sat at one table. An American group sat at another. The only other diners were sitting with your editor. Outside on the street, it was as if everyone else had been warned of an approaching tsunami; there was no one.

"Well, it's out of season all year round," our host replied. "It's a nice place to live. But it's not very lively.

"Montevideo used to be a lot richer. You can tell that just by looking at the public buildings. They're very grand. We couldn't build those places today. We don't have the money. But during the war years, Uruguay was booming. We were leading exporters of beef and grains. We're still leading exporters...but the margins are no longer there. You can make money in farming, but not enough to get rich."

We wonder what people are going to be saying a century from now.

"Yeah, Manhattan used to have the richest real estate in America...back in the financial boom. Wall Street was the center of the financial industry. People made fortunes from high-margin financial products. But then, the financial industry went into decline...and new financial centers in Shanghai and Singapore took the business."

Could New York have already passed its peak? Perhaps not quite. The papers are reporting record bonuses on Wall Street. But the story has an undertone of desperation about it...like the wild parties in Berlin in 1945, just before the Soviet Army arrived. Maybe that's why the bonuses are so high. Get it while you can! This could be the last hurrah for the US financial industry.

Private sector credit is still contracting. In fact, it's shrinking faster than at any time in the last 35 years. And this trend is not likely to change. As we keep saying - you're probably getting tired of hearing it - the private sector has 7 to 15 years of de-leveraging to do. The financial industry will be forced to downsize, along with the economy.

Wall Street's leveraged debt bombs are still blowing up. Banks are going under. As we reported yesterday, the 'second wave' of residential mortgage defaults may be just beginning. Commercial real estate debt isn't far behind...with no Fannie Mae to help the wounded or pick up the dead.

And how about all those private equity deals Wall Street financed? Of the top 10 deals from the bubble years, 6 are in trouble...and 4 have already defaulted.

The idea of private equity was that the hotshots were so smart they could take over a company, re-organize it, restructure it, and sell it back to the public market at a higher price. What they actually did was merely to load up the company with debt - using the money to pay themselves lavish fees.

And as we know...and maybe we alone know it...debt hurts. Run up enough debt and sooner or later bad things will happen. But not necessarily to the borrower!

Right now, the dollar is at a 15-month low. The speculators borrow dollars. Then, it doesn't matter what they do with them. Everything is going up against the greenback.

But that's why our Crash Alert flag is flying. Mr. Market doesn't like it when morons make money. We wouldn't be at all surprised to see these carry trades go bad in a big, big way. All of a sudden, stocks...bonds...emerging markets...commodities...and even gold...could go down against the dollar. Watch out!

The Dow rose another 20 points yesterday. It is now only 54 points below the 50% retracement level...where the bounce of 1930 peaked out.

Gold, meanwhile, held above $1,100.

As we were saying...once in a while, we think. The last few days have been so busy, we didn't have any time to think. But, now things are settling down, so we've had a chance to put our thinking cap on.

What are we thinking about?

Well, of course, we're trying to understand the basics... George Soros had the right idea: Find the story whose premise is false...and bet against it. What premise is false?

The major premise that almost everyone believes is that government economists can improve the workings of an otherwise free economy. That leads people to believe that the feds have pulled off a save...they've now got the economy well along on the road to recovery...the recovery is getting stronger as time goes by...and soon, the feds will begin to exit from their stimulus efforts.

The big question in most investors' minds is this: how quickly will the feds exit? As long as they keep up their stimulus efforts, investors expect rising prices for everything but the dollar.

Those who think the feds will be able to exit quickly believe growth will come without too much inflation. Those who think the exit will come slowly expect higher rates of inflation.

Well, guess what? The whole premise is false. From top to bottom. From beginning to end. Even the air it breathes is tainted with the smell of fraud and self-delusion.

The theory behind the recovery concept is that government spending and stimulus from the Fed has a "multiplier" effect. That is, the feds spend...the money goes into the economy...and then, the private economy multiplies the spending by growth in consumption and investment of its own. If there were no multiplier effect the whole exercise would be a waste of time, because we know that government spending in itself is a cost to an economy, not a source of real wealth. Government spending, generally, is a drag on prosperity. The Soviet Union proved that. The question remains however, can extra government spending at critical moments "prime the pump" so that it is multiplied by the private sector?

Answer: no.

"Our new research," writes economist Robert Barro in The Wall Street Journal, "shows no evidence of a Keynesian 'multiplier' effect...the available empirical evidence does not support the idea that spending multipliers typically exceed one, and thus spending stimulus programs will likely raise the GDP by less than the increase in government spending."

Now, we turn to the current situation. Is there any evidence of growth beyond the government's own stimulus efforts? From what we can see so far, again, the answer is 'no.'

The premise of recovery/multipliers/growth/and exit is false. We want to bet against it. Tomorrow we'll talk about how.

Real economists know that there are no secrets. You work hard. You invest carefully. You save your money. That's the best you can do. There are no multipliers. There are no miracle cures. There are no easy exits from trouble.

That's why the world has little use for honest economists; they tell you what you don't want to hear. So, people turn to the phonies...the charlatans...the imposter economists who say "yes we can!"

Trouble is, they can't.

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Government Debt
• Keynesians Believe Governments Have to Manage Economy in Macro-Economic Way
• Why Weren’t Economists On Top of This Thing?
• Can Government Bureaucrats do a Better Job of Allocating Capital than Free Markets?
• Have the Feds Given the Economy a Miracle Drug?

Why this three part thought experiment? Well, just because our analysts are in agreement that the cautious way forward is to surf the liquidity in the markets higher, your editor is, at heart, a massive worry wart. Plus, all these disaster movies about the end of the world must be affecting our state of mind, or amplifying its natural tendencies.

We're always worried about the worst-case scenario, always thinking of the things that could go wrong. This just seems like a prudent way to prepare. It will be better if these things don't happen. But let's just assume they will and work backward from there. And then let's figure out what you can do - if anything - to avoid getting wiped out again, and maybe even making a buck or two on it.

First cab off the rank is the total implosion of the Chinese economy. This might be bearish for Aussie resource stocks. But how likely is it to happen?

Well, not very likely if all you were looking at is the raft of official data released this week. Retail sales in China were up 16.2%. Industrial output was up 16.1%. And exports, even though they were down 13.8% in October, decreased at the lowest rate in ten months. Fixed asset investment for the year is up 33.1% over last year's pace.

You could take all of these as signs that China is leading the world to recovery and managing itself quite well. It should achieve 8% GDP growth. That's the growth rate that China's economic planners reckon the country must achieve to maintain high unemployment. And high employment rates promote political stability - valued above all else by a regime that makes free market gestures but still is run by old school communists.

What's more, if you take up the question we asked a few weeks ago - when is it in China's interests to allow its currency to strengthen - the answer is starting to emerge: when a stronger currency keeps inflation in check. China's currency managers are making noise about letting the Yuan strengthen against the dollar.

But it's not to please Barack Obama, who visits Beijing this month. A stronger Yuan, among other things, gives Chinese consumers more purchasing power. That might slowly reduce the contribution exports make to Chinese GDP (and to forex reserves which are then recycled into U.S. Treasuries.

Or it could all fall apart more quickly than anyone expected. Why?

China has massive over capacity in steel and cement. Granted, these two materials are quite literally the building blocks of industrial society. But according to Bill Powell in Fortune Magazine, China has enough spare production capacity in the cement industry to meet annual cement demand from India, Japan, and the U.S....combined!

This fact would be consistent with a country that's massively over-investing in fixed assets to achieve high rates of employment. And then there's steel. China's own National Development and Reform Commission says the country will have 250 million tonnes of excess steel production capacity by the end of next year.

Chinese steel production is approaching 600 million tonnes per year. But its current demand is around 350 million tonnes. That means it's either planning to put the rest of the world's steel makers out of business by dumping cheap steel on to global markets...or there is massive overcapacity and inefficiency in the steel sector.

Either way, it's probably a good idea to consider the possibility that China's investment binge is more fragile than it looks. In short, the bear case on China is that, "the Chinese have dangerously overheated their economy, building malls, luxury stores and infrastructure for which there is almost no demand, and that the entire system is teetering toward collapse."

Naturally this would be bad for Australia, whose economy is lately coupled with China's prosperity. It would argue for reducing your allocation to common stocks, raising your cash position, and not taking the China growth story at face value.

Next cab off the rank is global rush to refinance debt while interest rates low. Moody's reports that there is $10 trillion of bank debt maturing between now and the end of 2015. What's more, the average maturity of bank debt fell from 7.2 years to 4.7 years over the last five years.

This means bank debt (like sovereign debt, especially in the U.S.) is getting more interest rate sensitive. Not only do banks have to roll over a lot of debt in the coming years, they may have to do so at higher rates (assuming they can find takers for it.) Moody's is not confident.

In a research note published to clients, and also on the FT's Alphaville blog, Moody's analysts wrote that, "credit costs should continue to put banks' earnings and profitability under considerable pressure, which might cause investors to seek additional risk premia, as governments gradually exit from the direct support they have so far provided. In other words, we see weaknesses on both sides of the balance sheet, and we are concerned that the risks associated with both assets and liabilities may fuel each other, cause losses and undermine investor confidence."

Even if you concede that Moody's might be overly-dire now to make up for its non-existent warnings about the risk of sub-prime related debt, you have to take the warning seriously. In fact, in a report released last weekend, the IMF said banks were not out of the woods yet at all and remained at risk.

Its analysts wrote that, "Banking systems remain undercapitalized, suffering from impaired legacy assets and, increasingly, non-performing loans. Deleveraging pressures will likely remain a constraint on bank credit for some time. Activity in securitization markets remains dependent on public sector support. Moreover, large public interventions have transferred risk to sovereign balance sheets, raising market concerns that have abated somewhat recently."

We'll get to the sovereign balance sheets in a second. But in your financial disaster preparations, spare a thought for the banks. Serious problems remain. And if you're looking for where risk resides in the financial system today - the next AIG, or Mrs. O'Leary's cow if you prefer - you might not have to look any further than the banks.

But as the IMF noted, a great deal of private sector risk has been transferred to the public sector via bailouts, loan guarantees, and other schemes. This exposes sovereign borrowers like the U.S. and the UK to interest rate shocks (increased borrowing and debt service costs). But more importantly, these countries already faced fiscal dilemmas with ageing populations.

There is not much detail to add to this point. We've covered it before. But it's the best reason to own gold and tangible assets (your house, vodka, cigarettes). All the world's paper currencies are drowning under a sea of public sector debt that's becoming increasingly unsustainable. And this has happened at just the point where the Western welfare states will begin spending more money on caring for ageing populations.

Where will the money come from? Between a China meltdown, a bank implosion, and the rising risk of sovereign debt default, there are at least three known unknowns that worry us right now. And don't even get us started on the unknown unknowns.

Dan Denning
for The Daily Reckoning Australia

• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Chinese Economy Seems to be Growing
• Australian Iron Ore Shares on China’s Menu
• Chinese Surge in Construction Explains Pickup in Base Metals Stocks
• China Performs a Kind of Financial Alchemy

Australian baby boomers have never experienced a "rainy day" - so they've never planned for one.

But then why would you?

Over the last 20 years, virtually everything has gone up... and up...

A generational bull market has lifted the stock market, property values and commodity prices to dizzying heights. Most of us have felt the benefit of this in some way or other.

It's certainly made us feel a lot wealthier than we are. And when you feel wealthy, you tend to act wealthy.

And that's just what we've been doing - in some style... We've bought bigger houses, newer cars, nicer TV sets - and in the process, we've racked up more personal debt than the Americans were in just before the U.S. sub-prime crisis hit.

How deep in debt are we?

According to the Bank of International Settlements (BIS), during the 1980s, the ratio of household debt to disposable income for Australian households was around 45%. For every dollar an Aussie earned he owed 45 cents. Not ideal - but manageable.

Since 1990, the BIS reports that this ratio has risen rapidly, reaching an incredible 157% in December 2007. That means for every dollar the average Aussie earns, he owes $1.57.

In an October 2008 article, The Australian reported:

"By 2008, Australian households carried 35 per cent more debt relative to their income than Americans. The great Australian middle class has become more addicted to credit and more spendthrift than the US, the home of consumer capitalism."

We all know what happened in America after their debt bubble exploded...

But despite that warning, and despite debt far in excess of their incomes, Aussies are STILL spending money like it's going out of fashion.

In June 2009 the government handed out $900-a-piece to low and middle-income earners as part of a $23 billion stimulus package. By August, Australian National University economist Professor Andrew Leigh found that 40 per cent of those who'd received that cash had spent the lot. That's some stimulus for the economy!

"This is approximately twice as high as the share of United States residents who reported that they spent the tax rebates handed out in 2001 and 2008," noted Professor Leigh.

We all love spending free cash - who doesn't? - But every dollar you fritter away now is a dollar your future self will have to find when there's no regular money coming in.

The fact is, despite the overwhelming warnings, many of us spend more than we earn without any thought to the consequences... we believe that house prices will always rise... that high asset values equate to "true" wealth... and that we don't have to save any of our income because our super will provide us with a comfortable retirement.

But hang on a second - How often do you audit your super?

How regularly do you check to see whether your nest egg is still growing... or, at the very least, well protected against the economic downturn? Every month? Once a year? Never?

Have you checked it recently? Maybe you should...

Many Aussies opt for their company approved super fund and then forget about it, expecting to be handed a huge cheque at the end of their working life.

Granted, it's convenient: no research, no hassle, no worries. There's usually a big name behind the fund, and the glossy brochure your HR Manager hands you makes you feel cosseted and reassured.

It's the easy choice so you take it. And you stick with it - because you never physically see the money... it's just another deduction on your pay slip. It's not as if you're actually handing over piles of notes to someone to safeguard and nurture for you.

According to a recent report by superannuation research firm Chant West, the majority of retail super funds (i.e. yours) are classed as "growth" funds; defined as containing between 61 and 80 per cent of their allocation in assets such as shares. Even if you're invested primarily in a "balanced" fund, 40-61 per cent of your retirement cash will still be held in "growth" assets, says Chant West.

Growth assets are great when the market is going UP... but you want to limit your exposure to these assets when the market goes DOWN. And that's the problem: in the same report Chant West states that the average 'growth' super fund fell by 13% in 2008/09.

This is the worst return since the introduction of compulsory superannuation in 1992.

The worst return in the history of super.

That's a real kick in the teeth.

And the thing is, unless you've been paying attention, you may not have even noticed it. Rest assured, it'll smart pretty badly when you're still doing that early morning commute five... or even ten years after you'd planned to retire.

Please understand: sticking with the 'default option' of your company super allows someone you don't know to make all the crucial decisions that affect your financial future.

In terms of committing crimes against your future self, this is just about the worst thing you can do. Believe me - you may as well jump forward in time to the day you retire and punch yourself square in the face.

Kris Sayce
for The Daily Reckoning Australia

• Your Average Australian Super Fund
• World of Super Collides With World of Credit Crunch
• Is Kevin Rudd Planning to Steal Your Superannuation and Bankrupt Your Retirement?
• European Governments of the Eurozone are Separately Responsible for Their Euro-debt
• Your Actively Managed Superannuation Fund Cannot Beat the Market

"Why don't you move back into your own house," his father wanted to know.

"Dad, I've got a good tenant in there. Besides, it's not in very good shape. I'd rather sell it than invest more money in it. And there are so many places on the market, I can rent something better. Even after a big drop in prices it is still cheaper to rent than it is to buy something."

There are probably millions of homeowners who would like to sell - if they could. This hidden inventory of unsold houses will depress housing prices for a long time.

But there's a crisis coming in commercial real estate too.

"An extreme amount of commercial debt is to mature over the coming years," writes real estate investor George Karahalios in Marc Faber's Gloom, Doom and Boom Report. "And unlike the residential market, there is no safety net (Fannie Mae) for commercial loans. Instead investors must rely on financing through commercial banks, a few insurance companies, and other private lenders who now demand much higher interest rates and more equity for the risk associated with these investments. Thus, not even the Fed's printing presses can save commercial property prices, and I am expecting certain locations to crash, perhaps falling as much as 50-80% from the peak."

So you see, dear reader, there is bad news ahead - a lot of it. Stocks will go down. Gold will go down too - most likely - when people realize that the economy faces a long, deflationary depression...not a period of inflationary growth.

But while stocks are fair weather friends, gold sticks by you in foul weather too. Right now, gold is rising on good news. Eventually, it will soar when the news turns bad. (Though...not necessarily right away...)

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• The Housing Slump Has Fattened the Inventory of Unsold Homes
• Commercial Real Estate May Be the Next to Fall
• Trends Make Investors Less Afraid of Risk
• Ireland Going Through Same De-leveraging Process as the US
• Housing Prices Follow GDP Growth and Inflation

Most people find it both galling and absurd to see the bankers getting $10 million bonuses while there is 10% unemployment. Here at The Daily Reckoning, it's just a matter of curiosity. You'd think there would be more wage competition to drive down bankers' compensation. Why doesn't Goldman go to an unemployment line and make an offer...

"Any of you guys want to earn a $9 million bonus?"

Surely there would be a few takers. And Goldman would save $1 million.

Of course, we're joking. Banking is not a trade you can pick up just like that. Borrowing from the Fed at 1%...lending back to the Treasury at 4%...hey, it must take a few days of training to be able to turn around money like that.

On the other hand, there are periods when speculating for a big bank is a breeze. Over the last 7 months, for example, there was almost no way fed-financed traders could lose money. They borrowed dollars - the new carry-trade funding currency - at next to zero interest. It didn't matter what they did with it...they could trade it for Brazilian reals...or buy stocks in Singapore...or buy gold. Almost everything went up against the dollar.

Institutional investors - such as those managing money for banks - are judged on how well they do against the benchmarks, the averages, not on how much money they make or how many losses they avoid. If their colleagues are making money, they have no choice. They have to get in the game too.

So, they're in a "doom loop," where they continue to bid up asset prices - even at the beginning of a depression.

Meanwhile, over in the real economy...the deflation continues. David Rosenberg:

"It is like a magic show - the US economy is somehow out of recession with both employment and consumer credit outstanding still in full- fledged contraction mode.

"In September, total consumer credit fell $14.8bln making it the eighth month in a row of debt repayment - an unprecedented string of declines. Over this period, the amount of consumer credit (not including mortgages) that has come out of the system has totaled $163bln at an annual rate (or -6.3% at an annual rate). Looking at the fact that total household debt still exceeds long-turn norms of 60% by a factor of more than two, we are still in the early stages of a secular credit contraction that could well end up seeing another $5 trillion of debt collapse. This is a highly deflationary process; it will take time; and while we are bullish on gold and commodities strictly on global supply- demand imbalances, bonds remain a very good place because deflationary episodes provide solid real yields to investors."

Let's see. We've tried several ways to gauge how long it will take to de-leverage the private sector (which is another way of figuring how long this depression will last). At 6% a year - assuming private sector has about 2 times as much debt as it should have - it will take about 7 years to get down to a more comfortable level?

Did we do the math right? Well, who knows? But every time we do it, we come up with about the same answer - 7 to 10 years, more or less.

But it's not that simple. Because as the private sector de-leverages the feds try to prevent it...while they leverage up the public sector. This is bound to stretch the whole thing out...and bound to lead to some serious bust-ups.

Bill Bonner
for The Daily Reckoning Australia

• Baby Boomers Face Early Retirement With No Money Saved
• Feds Want to Increase the Money Supply and Induce People to Spend Money
• No Evidence of Recovery as Unemployment Getting Worse
• Have the Feds Given the Economy a Miracle Drug?
• Bankers Betting That the Money Given by Feds Will Be Worth Less Next Year