We are on vacation.

And so is the rest of France. The little church was crowed yesterday, mostly with Parisians and their children. It was also the 50th wedding anniversary for a friend…a retired army colonel and his wife. But the occasion was marked by more sadness than joy. Only three weeks ago, one of their sons was killed in a traffic accident. We felt so sorry for him; we didn’t know what to say. We wished he could worry about the stock market…or the monetary system…or the war in South Ossetia – but it was all no more than the buzzing of a fly compared to the loss of a child. We were meant to celebrate their golden wedding anniversary, but who could offer more than empty words?

“Oui, mon vieux…yes, my poor old fellow,” was all we could say. We hugged him and said nothing more.

Yes, we are on vacation…but this is The Daily Reckoning, after all. And there are always things to be reckoned with. Some important. Some trivial. Some sacred. Some profane.

But come 1PM, the lunch bell is going to sound and stand up from our computer and not touch it again until tomorrow. Then, after lunch, we’ll round up our crew of involuntary workers – three boys – and get to work. We have about 125 shutters in need of scraping and painting.

“Hey Dad, why do we have to do this? I mean, other people take a real vacation…I just spent the week with Paul and his family. They were really on vacation… and we just work.”

Henry also did some calculations: “Besides, if you add up all the expense of maintaining this place, it would probably be cheaper for us to take a vacation somewhere else…somewhere where somebody else paints the shutters…”

You’ll find our reply below…but first, we have the trivial world of finance to deal with.

Not that we have much to say about it. Yesterday, the Dow rose 302 points. The price of oil fell $5, to $115. After so many weeks of stormy, bearish, depressing news…it was time for a little blue sky and sunlight.

Stock markets all over the world are on the rise. Even financial stocks…and automakers…and airlines – all seem to be recovering.

One major exception – China. The Shanghai index fell more than 4% on Friday…and is still falling this morning.

But outside Shanghai, the word on the street is that “the worst is over.” They liken this to the ’70s, noting that after inflation peaked out, stocks rose strongly, and gold collapsed. In fact, the period – 1982-2000 – was probably the most agreeable financial period in most peoples’ lives. The Dow rose 11 times, while gold fell to less than a third of its peak. Interest rates went down in fits and starts over the entire period, not reaching a bottom until 2003. What could be better? Assets rose in price…while the cost of borrowing fell. This was the era of globablization, free trade agreements, cheap shipping costs, the entry of China and other nations into the world market system, Wal-Mart, technology and just-in-time inventory – all of these things helped to lower the cost of many manufactured goods. What a great time to be an investor!

But Daily Reckoners are warned: the stock market didn’t take off until stocks had been beaten down to very low prices – with P/E ratios of 5 to 8 (currently, they’re 14-18). Bonds didn’t take off until yields had peaked out over 15% (currently the 10-year note yields 3.95%). Which is another way of saying…the cost of borrowing didn’t go down until it had become almost impossible to borrow. And inflation rates didn’t retreat until they had hit 14% annually.

The moral of this story is simple enough. You have to fall down before you can pick yourself up.

Another big story in the financial press this morning has the dollar as its hero. The greenback rose three full pennies against the euro on Friday. It now stands at $1.50 per euro. Yes, the dollar is coming back too – or so you might think.

As to the dollar/euro exchange rate, we have no prediction to make. It’s like a spelling Bee where both contestants are dyslexics. Neither the euro’s masters nor Ben Benanke can spell “sound money.” The European central bank lends at twice the rate of interest of the Fed. But the Europeans are expanding their money supply faster.

Compared to dollars and euros, gold is a Webster’s Unabridged Dictionary. Every word is spelled perfectly. Our guess is that both dollars and euros will lose ground against gold. Here too, many commentators think the top in gold has come and gone. It’s down nearly 15% from its near-term peak. But again, it appears to us – and maybe to us alone – that the ’70s-style trends have yet to run their course. Stocks still have to be crushed. Inflation still has to reach higher than an official rate of only 5%. Yields have to reach higher than 4%.

And the monetary system rigged-up by the Nixon Administration in ‘71 still has to fall into ruin.

*** “Oil rises on troubles in Georgia…”

The headline is a sign of our time. Today, the world believes in money. In economics. In material progress. Everything else takes second, third, or fourth place. It is easier to see small changes in the price of oil than big changes in the way you look at the world. You can tell when the world changes; but when you change it goes unnoticed.

If this were August 1914, instead of August 2008, the headlines might read:

“French Bonds Fall on Invasion of Belgium.” Or, if this were August of 1939, the headline might read: “Oil prices jump on threatened German invasion of Poland.”

Or how would the modern press report the big event of 2000 years ago? “Miracle worker’s earnings cut short by untimely crucifixion…”

But in years zero, ‘14 and ‘39, money was not the main issue. People believed in politics, nationalism, racism, religion…and reported the news otherwise.

Today, it is money that counts.

The price of oil fell heavily last week. It ended Friday at $115. But this morning, it is rising – on news of a political struggle in South Ossetia. And if this continues, we wouldn’t count on the price of oil to stay ‘low’ for long. The only good news is that when energy is under the gun, the soaring oil price itself opens you up to all kinds of soaring investments. Read more here.

The region is between Russia and Georgia, on the Black Sea. Ossetians, whoever they are, have been there since the days when the ancient Greeks set up colonies around the Black Sea. In the 1930s, the Pontic Greeks were still there – until Stalin deported them to Kazakhstan. The Ossetians, too, disappeared into the maul of the Soviet Union. They were forgotten for most of the 20th century. Then, when the Soviet Union disbanded – there they were. But who then had the right to tell the Ossetians what to do? The Russians? Or the Georgians? The Russians expressed themselves on the issue over the weekend. According to one report, 2,000 people have died in the fighting.

U.S. Vice President, Dick Cheney, had Georgia on his mind over the weekend. He reportedly said that this violence “must not go unanswered.” What sort of response he had in mind, we don’t know. But inasmuch as the United States and Russia are the world’s two most heavily armed nuclear powers, there may be more at stake than the price of oil.

*** “If you added up the cost of maintaining this place, it’s probably a lot more than a nice vacation,” Henry argued. “We had to replace the roof a few years ago. We have Damien, [the gardener] who keeps an eye on the place. We had to have the plumber come and fix the furnace. You put a new door on the kitchen. It must cost a lot of money. We could have gone to spend a month in a nice hotel on the Cote d’Azur, for example.”

Henry had just come back from a week spent with friends. They didn’t paint shutters, or fix stone walls, or weed the garden. Instead, they went sailing…and to movies…and restaurants.

“Oh…and I was surprised by how much people hate Parisians,” said Henry. “They think Parisians are rich and snobby. And they’re right. You know Paul’s father would see someone with Paris license tags, doing something stupid, and he’d roll down the window and yell out – ‘Go back to Paris…’ or something like that.”

“But wait…Paul’s family is from Paris…they are Parisians…”

“Yes, but his father got local license tags. So when he’s on vacation, he pretends to be from the area and yells at the Parisians…

“But we had a good time sailing…it was nice to take a real vacation. Not like around here. We never get a vacation here, because there’s always so much work to do just to keep the place from falling down. Really, Dad, I don’t see the point….”

Henry is right, at least insofar as the money is concerned. When you add in all the costs of maintaining a summer house – or, at least this summer house – it is far more than the cost of a real vacation. In addition to all the costs Henry mentioned, there’s the cost of heat. Even though we’re rarely here in the winter, we still have to heat the place or it will soon be ruined by mildew. And here in Europe, it costs a fortune to heat a large, old, un-insulated house through the winter. Then, there are taxes…insurance…and the inevitable repairs.

What we’re discovered here in France is the same thing that Americans all across the nation are discovering – houses are ways to spend money, not to make it.

“Well, why do you keep it?” Henry wanted to know.

“Sentimental reasons, Henry. This isn’t an investment. And it’s not just a vacation spot. This is our home. We’ve spent the last 13 years fixing it up. We’ve restored it. We’ve planted trees and gardens. And you children have grown up here.

“Besides, our lives are otherwise rather nomadic. I work in London. Your mother and Edward live in Paris. You children are spread out all over the world. You’re going to be in Virginia next year. Maria is out in Los Angeles. We need a place to call home…a place to keep our sacred family documents….”

“You mean, a place to keep grandma’s recipe for bread pudding and Maryland beaten biscuits?”

“Yes…and your monkey outfit from when you were in the school pageant… We need a permanent family stronghold…a family seat…a place where the whole family could gather every summer.”

“Well, why didn’t we just stay at the family farm in Maryland?”

“Because my business took us to Europe…and because the whole area changed so much…with all those shopping malls and housing developments…it didn’t seem like home anymore. We had to retreat…”

“Well, I don’t mind that…I like this place. I just don’t like having to work all the time we’re here.”

“But that’s just part of the charm of it. Imagine if we had gotten a condo at the beach at Ocean City? We’d go crazy. We’d just sit around and read all the time. Here…we get to do a little stonemasonry in the morning and paint the shutters in the afternoon…”

“When I grow up, I’m going to get a place at the beach…and spend the summer there. You’re going to have to paint the shutters by yourself.”

Until tomorrow,

Bill Bonner
The Daily Reckoning

Source: Can You Spell ‘Sound Money’?

Both ended up backtracking on previous statements, as their ill-conceived cures for the broader U.S. economy were stripped of any relevancy by a tumultuous and unforgiving credit market.

Fannie Mae (FNM) dropped $2.13 a share, or 22% yesterday, to close at $7.60 share. Freddie Mac (FRE) sank $1.77, or 25%, to close at $5.34 a share. The beleaguered mortgage giants dragged the market down with them, as the Dow Jones Industrial Average closed down 92 points, or .84% at 10,962.54. It had earlier fallen as low as 10,840.81. The S&P 500 Index closed at 1,214.91 down 13 points, or 1%.

After saying Sunday that Fannie Mae and Freddie Mac “play a central role in our housing finance system and must continue to do so,” Paulson amended his comments to the Senate Banking Committee, saying his plan “is aimed at supporting the stability of financial markets, not just these two companies.”

“Let me stress that there are no immediate plans to access either the proposed liquidity or the proposed capital backstop,” Paulson added. “If either authority is used, it would be done so only at Treasury’s discretion, under terms and conditions that protect the U.S. taxpayer.”

Similarly, Federal Reserve Chairman Ben S. Bernanke was forced to rethink his previous statements concerning the progress of the economy.

After saying in June that the risks of a “substantial downturn” had diminished and the Fed would shift its focus to resisting “an erosion of longer-term inflation expectations,” Bernanke said before Congress today, that the economy “continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil [and] food.”

Now, as credit markets tighten and inflation continues to strengthen its grip on the U.S. economy, both Paulson and Bernanke have the unenviable task of shepherding the economy through one of the most difficult economic climates of the past century.

Paulson’s Predicament

After opening higher Monday following Paulson’s remarks and a successful sale of short-term debt at Freddie, both stocks resumed their slide with each company falling more than 30% in the past two days. Fannie Mae has lost 81% year-to-date, while Freddie Mac has dropped 84.5%.

“The impact of Sunday’s announcement by the Federal Reserve regarding its mortgage bail-out plan for Fannie Mae and Freddie Mac remains somewhat derided in the market,” James Hughes at CMC Markets told the Financial Times. ”It has apparently done little more than underline the perilous state of the U.S. economy.”

Both Freddie and Fannie have cash on hand, and both meet their regulatory capital requirements. It also looks as though both firms will also be bolstered by U.S. Treasury Secretary Henry Paulson’s rescue plan, which includes generous credit lines and a pledge by the U.S. government to purchase equity in the companies as needed.

But government assistance notwithstanding, investors and analysts anticipate falling house prices and an increasing number of mortgage defaults will incinerate what little capital the companies have left. Their balance sheets are also highly suspect, though Freddie Mac looks far worse off than Fannie Mae.

At the end of the first quarter Freddie’s balance sheet showed assets of $803 billion and shareholder equity of just $16 billion, CNNMoney reported. That means Freddie has just one dollar in equity for every $50 of mortgages and other assets it holds. The company’s mortgage portfolio is even more disconcerting, as it shows just 70 cents worth of equity for every $100 worth of business on its books.

“Is this enough equity when your business consists of buying and guaranteeing mortgages?” Len Blum, a managing director at New York investment bank Westwood Capital, wrote in a recent report quoted by CNN. “How about when you conduct these activities in markets falling by 20% or more?”

Finally, according to the fair-value balance sheet, which reflects the value of Freddie’s assets rather than their cost, the company’s shareholder equity stands at negative $5.2 billion. Using fair-value accounting, Fannie Mae shareholders are still up $12 billion.

Also, as other lenders have withdrawn from the mortgage market in the face of plummeting home values and a mountain of foreclosure filings Fannie and Freddie have been left to pick up the slack to the point that they are now involved in 80% of U.S. mortgages.

With so much on the line, the failure of Freddie Mac and Fannie Mae would be cataclysmic. And not just for the U.S. market, but for global investors.

Because government-sponsored enterprises (GSEs), such as Fannie and Freddie, offer higher yields than treasuries and enjoy implicit assurances from the U.S. government, they are very appealing to foreign investors who hold approximately $1 trillion in GSE debt.

Indeed, if Fannie and Freddie were to fail, it would undermine these investments and cost international investors dearly.

But the effects may not last, as unemployment continues to rise and crude oil supplies tighten.

Record high gasoline prices padded the report, but purchases still increased in every other sector. Gasoline sales jumped 2.6% last month and have gained 13.8% in the past year. Excluding gasoline, sales still climbed 0.8%.

“Yes, we bought a lot more gasoline as prices skyrocketed,” said Joel Naroff, president and chief economist at Naroff Economics Inc. “But the sales gains may not have kept up with the cost increases. More importantly, you name the good, electronics, appliances, clothing, health care, food or general merchandise and sales rose. We even ate out more.  That is impressive, to say the least.”

Many economists were impressed by the figures as retail sales rang up $385.4 billion for the month. However, most attributed the growth to the $50 million in economic stimulus payments the U.S. government sent out in May, and analysts are divided on whether their positive effect will continue.

“The full impacts of the rebate checks are still to come as people are still receiving them,” Naroff said. “That holds out hope that consumption will continue to expand through the summer.”

Then again, unemployment is on the rise having reached 5.5% in May, a 0.5% increase from April – the largest monthly increase in 23 years. Initial claims for unemployment benefits rose to 384,000 last week from 359,000 for the week ended June 6.

“This good [retail] report suggests the tax rebates are having an impact,” Mark Zandi, chief economist at Moody’s Economy.com, told Bloomberg in a radio interview. “As these effects fade, the weaker job market will take over.”

Also, after nine months cutting interest rates and lending freely to financial firms hoping to ease the pain of the credit crunch, U.S. Federal Reserve Chairman Ben S. Bernanke is has been phrasing a reversed course to battle inflation.

“The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so,” Bernanke said earlier this week. “The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations.”

Coupled with tough talk from the European Central Bank, the message is clear: The U.S. Federal Reserve can no longer afford to stand by and watch the value of the dollar plummet. And if that means the economy and investors limp through the remainder of 2008, so be it.

“The immediate effect from this dramatic shift in policy priorities has been to ‘drain’ visibility, confidence and liquidity from financial markets,” Tullett Prebon economist Lena Komileva wrote this week, according to Fortune. “With monetary policy adopting the role of a risk-driver rather than a source of relief for financial markets, current conditions are actually worse than they were last August when the credit crunch erupted.”

Source: Stimulus Checks Push Retail Sales Rally, Economy Still Facing Uphill Battle