Today, we’re taking a different tack with Notes. Let’s call it the “what if” issue. You know what we think about the rally in stocks and the green shoots optimism on TV. To us, at least, it’s bunk.

Thirty-four million Americans are now on food stamps. And legions more are unemployed. The debt deleveraging that began with the subprime collapse has hardly begun, and the only thing preventing massive further unwinding is a bankrupt government spending out of an empty pocket. Stocks are up. But the inconsistencies of this rally (junk ahead of quality, low volumes, inside selling, short covering, etc) signal more pain ahead.

And even if USA Inc does ‘recover,’ nobody knows (or dares to imagine) what that ‘recovery’ will be like. All we do know is that in order to get us there the feds are engaged with what former Bank Credit Analyst editor Tony Boeckh call the “Great Reflation Experiment.”

This great experiment is really two great experiments. The first is an unprecedented (in peacetime, at least) rise in federal government deficits, debts, obligations and contingent liabilities. It involved Uncle Sam selling IOUs to the world to fund its bailouts of banks, financial market backstops and giant pork-laden ‘stimulus’ programs.

The second experiment is monetary. It involves the expansion of the Fed’s balance sheet to accommodate the toxic junk created by Wall Street and encouraged by Washington during the boom. It also involves the whole scale creation of new currency to mitigate the massive borrowing the government is engaging in.

Each of these massive experiments in “something for nothing” economic policy on their own is the financial equivalent of the atomic bombs that America dropped on Hiroshima and Nagasaki to end World War II. They might “work” in their short-term goals, but they are genies that will not be easy to put back into their bottles.

Is this post-atomic landscape going to be pretty? According to Boeckh, far from it. This is what he sees as a result of the twin jets of monetary and financial ‘stimulus.’

Anaemic growth, falling tax revenue, increased government spending, and bailouts of indigent states, households, businesses, along with an aging population, will all undermine public finances to a degree never before seen in peacetime. According to CBO data, government debt could reach 300% of GDP by 2050 as contingent liabilities are converted into actual government expenditures. This massive peacetime deterioration in public finances will have grave consequences for living standards and asset markets, particularly in the longer run.

Here we must turn back the clock. Because as Boeckh rightly points out (to our minds, at least) is that the feds fiscal and monetary response to the economic crisis is not some once off event, but part of an overarching “super cycle” of inflation, correction, then reflation. It’s what Boeckh calls the “debt super cycle.”

The Crash of 2008/9 should be seen as yet another consequence of long-term, persistent US inflationary policies.

Policymakers, money managers, and most forecasters have argued that the crash was a “black swan” event, meaning that it had an extremely low probability of occurrence. That is grossly misleading, as it implies that the crash was so far beyond the realm of normal probabilities that it was unreasonable to expect anyone to have foreseen it. That argument has been used to justify the widespread complacency that prevailed in the years leading up to the crash. Policymakers are still failing to recognize the systemic causes of the crash and seem to believe that enhanced regulation will prevent history from repeating. While it is true that regulators were asleep at the switch or looking the other way, they were not the cause.

Inflation doesn’t stand still. It tends to establish a self-reinforcing cycle that accelerates until the excesses in money and credit become so extreme that a correction is triggered. The bigger the inflation, the bigger the correction. Once a dependency on credit expansion is well established, correcting the underlying imbalances becomes extremely difficult. Reflation has occurred after each major correction, and this one is proving no exception. Return to discipline in the current environment would be too painful and dangerous. Once on the financial roller coaster, it is very hard to get off. Moreover, the oscillations between peaks and valleys become increasingly large and unstable.

See, whatever way you cut it, what we’re all experiencing now is fallout from an unprecedented dependency on debt. Sure, the likes of Congressman Barney Frank will look you right in the eyes and tell you “it was the greedy bankers that did it” (a message that is being repeated all over the world). But this misses the point.

Sure, Wall Street “got drunk,” as President Bush put it so eloquently in the dying days of his presidency, but Wall Street didn’t mix the drinks. The hooch was served up by the Federal Reserve and their political masters, who were determined to avoid election defeat as a result of a bad economy. (Bush senior had already been there in 1992, and it wasn’t pretty.)

Now, before you write in telling us that we’re “Bush haters.” Let’s get something straight: we don’t care much for either side in the American political circus. Bush doubled the deficit in his eight years in office. And Obama has doubled it again in a few short months. (The last US president who strikes us as even mildly decent was President Coolidge. At least he understood that the best thing a president can do is nothing at all.)

The point, dear reader, is this is a mess of our own making. A mess created by the American dream of “something for nothing” on a colossal scale. Just consider the following two charts. They tell the whole story perfectly.

The first of these charts shows the private sector debt overhang relative to GDP. That gap you see between the black line of what America produces as an economy each year and the dotted line of what its citizens borrow is the country’s “something for nothing” deficit. Print it out, and stick it to your fridge door. That way when your taxes rise and your standard of living drops, you can remind yourself of how we got into this mess in the first place.

The second chart is the result of first. It shows the projected US national debt. And those dotted lines you see climbing limberly up the right hand side of the chart represents America’s final soaring act of desperation… the last bubble, if you will… Someday this government debt bubble will burst too. And the rest, as they say, will be history.

So what can you do about all this? As Boeckh says, investors are also in an extraordinarily difficult predicament as a result of the debt super cycle. Pensions have been devastated. Stocks wealth has been halved. And housing equity is no longer a guarantee of a secure financial future.

Boeckh says that the fiscal and monetary experiments will have three specific consequences.

1. The high level of excess capacity in the world will mean that inflation won’t show up in consumer prices immediately. In fact, Boeckh reckons consumer price inflation is “a long way off.”
2. Massive monetary stimulus is good for asset prices in the near term (e.g. stocks, bonds, houses, commodities).
3. There is a “major” risk to dollar stability as the US floods the market with dollar-denominated debt and freshly printed dollars.

There are three obvious ways to diversify away from dollar assets, according to Boeckh. These are as follows:

1. The first is investing in high-quality US equities that have a majority of their earnings and assets in hard-currency countries.
2. The second is investing in gold and related assets. Gold will probably remain in a tug of war for some time. On the negative side, it is faced with nonexistent global price inflation, even deflation, and a sharp decline in jewelry demand. On the positive side, concerns over monetary and fiscal debauchery will almost certainly heat up. As the odds of the latter increase, gold will be a major beneficiary, and investors should have a healthy insurance position in this asset class. If you want to invest in gold and are looking for a way to score a 1495% profit, check out this new system we’ve just heard about.
3. Third, most foreign currencies will also benefit from these fears, and hence investors can also protect themselves by diversifying into non-dollar assets in the best-managed countries. Some of these are emerging markets like China, which are liquid, in surplus, fiscally stable, and still growing well in spite of the global economic downturn. If and when the world economy begins to recover, and should price inflation stay low, asset bubbles are likely to recur. Where and when is always hard to tell in advance. Good prospects are in emerging-market equities, commodities, and commodity-oriented countries.

Policymakers, money managers, and most forecasters have argued that the crash was a “black swan” event, meaning that it had an extremely low probability of occurrence. That is grossly misleading, as it implies that the crash was so far beyond the realm of normal probabilities that it was unreasonable to expect anyone to have foreseen it. That argument has been used to justify the widespread complacency that prevailed in the years leading up to the crash. Policymakers are still failing to recognize the systemic causes of the crash and seem to believe that enhanced regulation will prevent history from repeating. While it is true that regulators were asleep at the switch or looking the other way, they were not the cause.

Inflation doesn’t stand still. It tends to establish a self-reinforcing cycle that accelerates until the excesses in money and credit become so extreme that a correction is triggered. The bigger the inflation, the bigger the correction. Once a dependency on credit expansion is well established, correcting the underlying imbalances becomes extremely difficult. Reflation has occurred after each major correction, and this one is proving no exception. Return to discipline in the current environment would be too painful and dangerous. Once on the financial roller coaster, it is very hard to get off. Moreover, the oscillations between peaks and valleys become increasingly large and unstable.