Bill Bonner (The Daily Reckoning, UK Edition):
The Dow fell slightly on Friday. Oil ended the week at $77. The dollar went nowhere.

But gold rose to a new high – $1,146. Today it’s hitting more new highs above $1,160…

Whatever else may be going on, there’s a real bull market in gold. It’s a bull market that began ten years ago. If you’d bought stocks then, you’d have about what you have now… less inflation. If you’d bought gold… you have about 4 times what you had then.

Today, a quick glance at a chart shows gold looking a little toppy. Expect a correction. But remember, this is a bull market. In a bull market, you buy the dips.

Stocks, meanwhile, are in a bear market. In a bear market, you sell the rallies. This looks like a good time to sell – if you haven’t done so already.

“Take Your Gains,” says Forbes. And once you’re out of stocks, stay out until the bear market is over… probably at around 3,000 – 5,000 on the Dow. When the price of gold equals the price of the Dow, it will be time to switch.

We haven’t seen the last of this bull market in gold. It’s what you buy when you think government is making a mess of the monetary situation. You put your trust in gold as an antidote… as protection… as wealth insurance.

Are the feds making a mess of the monetary situation? Oh dear, dear reader… please ask us something harder. Trillion dollar deficits as far as the eye can see… Stimulus spending that turns the US into a Zombie Economy… Handouts to the bankers… gifts to the carry traders…

The feds are out-doing themselves… more below…

As for the bear market on Wall Street, investors are counting on a miracle… a ‘recovery’ that doubles corporate earnings in just a couple years. They think it’s “just like 1982”. Of course, it is just the opposite of 1982… see the table below.

Besides, there is no recovery… and profits will go down, as businesses compete for less spending.

The recovery may be all in your head, writes Robert Shiller, in the New York Times:

“Consider this possibility: after all these months, people start to think it’s time for the recession to end. The very thought begins to renew confidence, and some people start spending again — in turn, generating visible signs of recovery. This may seem absurd, and is rarely mentioned as an explanation for mass behavior late in a recession, but economic theorists have long been fascinated by such a possibility.

“Back in 1931, for example, The New York Times attributed the emerging economic cataclysm to a “mood of pessimism which had been carried to grotesque extremes.” In 1932, it compared reckless talk about “depression” to shouting “fire” in a crowded theater.”

It doesn’t matter what anyone says. It’s a depression. It’s nothing like the garden-variety recessions of the Post-War period.

It’s a depression because of the nature of the work it has to do. It has to clean up 3 decades’ worth of filthy balance sheets.

Click here for the rest of Mr. Bonner’s insightful commentary at The Daily Reckoning, UK Edition.

Martin Wolf, speaking, gravely, for the world’s intelligentsia in The Financial Times last week, proclaimed that: “the only thing worse than rescuing the system would have been not rescuing it.” But he is wrong; of all the many blessings economists may bestow upon a grateful people, improving the economy is not one of them. An economy is a natural thing. It can be improved by the striving of entrepreneurs, the prudence of bankers, and the sweating of field hands. But when it comes to the macro-economic policy, forbearance is the quality that pays. Any initiative on the feds’ part inevitably makes things worse.

The Bubble Era, like the Great Depression, was largely –but not completely – the result of government initiative. Artificially low interest rates – intended to counter the modest downturn of 2001 – sent the wrong message. Consumers – notably those in Britain and America – bought things they couldn’t afford. Producers – notably those in Asia – made things for which there was no real market. Debt piled up. Mountains of it.

As consumers bought more and producers made more the economy grew. But much of the economic “growth” of the 2001-2007 period was fraudulent. It was based on debt spending, not on genuine increases in purchasing power. Debt pretends to be real money. It looks like the real thing, but it is not. It stimulates the economy like counterfeit money. It causes production and consumption, but of the wrong sort. Former Reagan era Office of Management and Budget director David Stockman estimates the level of “counterfeit GDP” at $4 trillion in the US alone.

The fraud was discovered, though misunderstood, when sub-prime debt began to implode.

Finish reading the complete article at The Daily Reckoning.

Oil didn’t move yesterday. Neither did gold.

The Wall Street Journal reported that markets were reacting to “mixed data”.

That is to say, some reports were encouraging. Others were not. It was as if one weather forecaster called for a blizzard. The other for sunny skies and warm temperatures. Investors didn’t know how to dress.

Among the dark clouds was an item on the falloff in tax revenues. States are having a hard time balancing their books, because their tax receipts are declining. The WSJ reports that they are running 17% below last year.

Since states cannot print money, they’re forced to make cutbacks – typically reducing hours worked per employee as well as the total number of employees. This is a bad thing, says the report, because it increases unemployment and lowers the wage base. This leads to less consumer spending.

Another little cloud appeared yesterday (in addition to the consumer confidence numbers): the vacation timeshare market is collapsing at a record pace.

Well, don’t worry about it. We met a guy who explained the timeshare business to us.

“What you’re selling is a dream. You bring them to the property. You make sure they have a good time. And then you do to the numbers with them. You show them how much they save by coming to your property rather than on a typical vacation. And then you show them the other properties that they can exchange for. They think they can buy a cheap property and then exchange with an expensive timeshare. But it doesn’t work that way. They get stuck in the cheap unit and the dream gets a little faded… And then, they stop coming… and then they try to sell the timeshare. Timeshares are rarely a good investment.”

Besides, timeshares are a small, quirky part of the housing picture anyway. The real story is in the regular housing market. There, if you believe the forecasters, it’s sunny skies.

House prices seem to be stabilising. In some areas, they are going up. Of course, in some places you can get a house at half the price it sold for two years ago. That lures buyers back into the market. If we wanted a house to live in, we might be tempted too. That’s why we like falling housing prices: we get more for our money. But most people want a rising housing market. They think it makes them richer.

They’re likely to be disappointed. They show up at the beach with their umbrellas and sun-tan lotion… just as a winter storm hits the coast.

Forbes lists eight reasons to “remain worried about housing”.

• The federal tax credit, worth $8,000, is set to expire at the end of November. That will make housing $8,000 more expensive for first-time buyers.

• The Fed is also ending its $1.45 trillion shopping spree. It has been supporting housing by buying mortgage-backed derivatives. What will happen when it stops?

• Mortgage lending standards are tightening up generally.

• Houses are still not cheap. Forbes cites Shiller’s numbers, putting the average house price 41% higher than it was in 2000. Incomes did not increase during that period; ergo, houses are still too expensive.

• Damaged psychology. It will take time for potential homeowners to get over the shock of a bear market.

• The end of summer has arrived. Housing sales always go up in the summer. People relocate in summer, during the school break. Then, sales fall with the autumn leaves.

• There are still huge numbers of houses that will be repossessed. Forbes says only 12% of option ARMs have been reset. More repossessions will increase the supply of desperate sellers and decrease prices.

• There’s a ‘shadow inventory’ hanging over the housing market. It could be vast. Everyone knew it would be hard to sell a house in 2009. Many potential sellers held back, waiting for the market to stabilise. As they put their houses up for sale, that too will hold prices down.

Some wiseacre economist has probably already come up with eight reasons why housing prices will go up. But the key thing to recall is that this is a depression. It’s a major restructuring of the economy, not a standard post-war recession. After 64 years, the consumer has finally rung a bell. He has reached his limit. He cannot borrow more. He cannot spend more. He is finally cutting back. That fact will echo through the entire world economy – and through the US housing market – for many years.

Houses, like stocks and corpses, may bounce. But they will not begin a real bull market again for a long, long time.

***Our old friend Marc Faber is “highly confident” that things will turn out badly.

“The future will be a total disaster, with a collapse of our capitalistic system as we know it today, wars, massive government debt defaults and the impoverishment of large segments of Western society,” he writes.

“We have a money-printer at the Fed,” he continues, which guarantees runaway inflation, wholesale debasement of the dollar, and a major lowering of living standards for most Americans and many Europeans as well.

Meanwhile, Paul Volcker says that China’s rise merely “highlights the relative decline of the US.”

So there you have it: China on the way up, America on the way down .

That’s the drama that we’re watching every day here at the Daily Reckoning. In our view, the peak of US wealth and power probably came during the period between the fall of the Berlin Wall and the fall of Lehman Brothers. But there are probably a lot more shoes to drop before people are fully aware of what is going on.

The way we see it, almost the entire 20th century was a mistake, a dead end. Europeans were clearly on top of the world when the century began. Then, after WWI the Europeans in America took the lead role. But WWI shook their faith in their evolving political order.

Not long after, German hyperinflation and the Great Depression shook their faith in their economic and financial order. This left a huge vacuum, which was soon filled by ruthless adventurers and ideological schemers. Much of the rest of the century – from 1939 to 1989 – was spent in hot wars and cold wars against these Bolsheviks, Fascists, Stalinists and Maoists.

In the end, the more reasonable and consensual societies of the West won the battle. But they, too, were transformed by 50 years of war and nearly a century of bad ideas .

“Whoever fights monsters should see to it that in the process he does not become a monster. When you look into the abyss, the abyss also looks into you,” Nietzsche warned.

Looking into the abyss created by Mussolini, Hitler, Tojo, Pol Pot and the rest, Western societies decided both to fight them and to join them. Tax rates soared. Regulations multiplied. University professors taught socialism, Freudianism, modernism, cubism, feminism, racism… and every other ‘ism’ they could think of. Parents spent good money to send their children to universities that turned them into mush-heads.

And – perhaps most ominous – in the United States of America, the military grew into a greedy, grasping goliath… the very thing Eisenhower had warned against.

Then, there were counter-trends in the 1980s… led by Margaret Thatcher in England and Ronald Reagan in the US. But these were mostly frauds . Top marginal tax rates were rolled back. And there were some cuts in regulatory procedures. But government spending tended to go up anyway. Worse, Ronald Reagan mistook the Soviet Union for a genuine threat and increased military spending even further to combat it.

And now, the US staggers under the weight of its eternal wars… its imperial illusions … and its everlasting efforts to provide bread and circuses. If it kept its books like a private enterprise, it would be broke. If it were a public corporation, it would be de-listed.

Still, it spends and spends… and there is no stopping the spending. Trillions are spent on wars in Iraq and Afghanistan, for no apparent reason. But who complains? Too much money is at stake. There are too many lobbyists for too many industries and too many special interests involved. Military spending – even in a time when America faces no substantial challengers – cannot be rolled back. Neither can social spending.

Marc Faber is right. There too, there are too many people with too many dogs in this fight. Both military and social spending will continue to expand until the empire is ruined.

Until tomorrow,

Bill Bonner

Source: A Century of Bad Ideas

Far be it for us to call an end to the party. We’ve been warning of the dangers of this rally since it began. And it looks like nobody’s been listening: stocks have continued to climb in the most dizzying Wall Street rally since the infamous bear market bounce of 1929-1930. But that’s what we do here at Notes – we bring you the other side of the economic story. So we figure we’ll plow on.

Legendary short-seller Doug Kass called a bottom in US stocks in March. He was dead on with this call. Now Kass is has turned seriously bearish on the prospect – now almost a matter of dogma in the mainstream financial press – of a V-shaped recovery.

Kass’s reasons for being suspicious of the mainstream’s recovery mantra are eminently sensible… which almost guarantees that nobody will pay any attention to them. They’re even (gasp!) realistic and based on observable facts.

1. Cost cuts are a corporate lifeline and so is fiscal stimulus, but both have a defined and limited life.

2. Cost cuts (exacerbated by wage deflation) pose an enduring threat to the consumer, which is still the most significant contributor to domestic growth.

3. The consumer entered the current downcycle exposed and levered to the hilt, and net worths have been damaged and will need to be repaired through higher savings and lower consumption.

4. The credit aftershock will continue to haunt the economy.

5. The effect of the Fed’s monetarist experiment and its impact on investing and spending still remain uncertain.

6. While the housing market has stabilized, its recovery will be muted, and there are few growth drivers to replace the important role taken by the real estate markets in the prior upturn.

7. Commercial real estate has only begun to enter a cyclical downturn.

8. While the public works component of public policy is a stimulant, the impact might be more muted than is generally recognized. There may be less than meets the eye as most of the current fiscal policy initiatives represent transfer payments that have a negative multiplier and create work disincentives.

9. Municipalities have historically provided economic stability — no more.

10. Federal, state and local taxes will be rising as the deficit must eventually be funded, and high health and energy bills also loom.

(Hat tip, MarketFolly.com)

Reason number 10 scares us, dear reader. Kass is really just stating the blindingly obvious: massive deficits will have to be paid for sooner or later, and when they do, they’ll be paid for by higher taxes.

This hike in taxes isn’t lying somewhere in the distant future, either. It’s happening right now. This from Kass:

We have already witnessed the start of what is likely to become an avalanche of changing tax policy. New York City imposed its first sales tax increase in 35 years (rising from 8.375% to 8.875%), and, on the same day, the state of New Jersey imposed an additional tax hike on wholesale liquor distributors’ sales of liquor and wine, which is sure to be passed on to the consumer. In Oakland, Calif., even the “high life” is being taxed as the city has recently passed a tax on marijuana sales and the state of California appears to be close in following Oakland’s example.

This is just the start of a nascent and broad trend toward much higher taxes, a growth-impeding and P/E-diminishing secular development

Kass not only identifies the obvious when it comes to the future of the US tax regime, but he also hits the nail on the head (in our humble opinion, at least) when it comes to the future of US stocks.

The market optimism that we are now experiencing in the expectation of a clean handoff of the baton of stimulation from the consumer (2000-2006) to the government (2008-???) might be more short-lived than many believe, as the price of stimulation, regardless of whether it’s source is the private or public sector, holds the promise of being more of a growth-retardant. With the debt super-cycle continuing apace (but in a public sector context), the fragility and inherently unstable “balance of financial terror” argues for a not-so-benign and extremely volatile stock market future.

Unquestionably, the animal spirits have been in full force as shorts are scrambling to cover and many more are joining the ever more vocal and growing bullish chorus. But to me, the margin of safety is becoming ever more thin as the enemy of the rational buyer – namely, optimism – reaches new heights.

In summary, since a self-sustaining economic recovery appears doubtful, I do not believe that we have started a new bull market. Rather, it is more than likely that economic growth will disappoint in late 2009/early 2010 as the domestic economy confronts many of the emerging secular challenges discussed above.

*** Here’s Kass’s model portfolio as of June 2009. Interestingly, he recommends holding 29% in cash… a very smart move in our opinion, considering the state of the markets right now.

http://4.bp.blogspot.com/_9MYixPWxtF0/SjbACP6_syI/AAAAAAAAAn0/dG_f2yx8p0I/s1600/doug-kass-model-portfolio.jpg

Boosting stocks, of course, was “better-than-expected” news about US GDP. This was typical second derivative stuff: the pace of decline slowed, but the figures were still heading in the wrong direction. According to the Commerce Department, US GDP shrank “only” 1% year-on-year in the second quarter, 0.5% less than forecast. And this was taken as reason for optimism!

The problem is the Commerce Department also revised down its reading of first quarter GDP to 6.4% from 5.5%. It will revise down the last quarter’s numbers, too. As underground economic number cruncher John Williams of ShadowStats.com points out:

The second-quarter GDP “improvement” was only in terms of relative quarter-to-quarter growth (1.0% contraction versus a 6.4% contraction in the first quarter), and was needed badly for political and financial-market hype. Keep in mind that this “advance” estimate is roughly 90% guesstimate (only two of three months of trade data are available, for example), and it is the most heavily politicized of the major economic series.

The feds are clearly playing the optimism game. Expecting the truth from these guys is like expecting a Michael Jackson comeback tour – it ain’t gonna happen.

This is not a good time to be asleep at the wheel as an investor. And by asleep at the wheel we mean sucking up the manufactured optimism and hype of Washington, Wall Street and the mainstream financial press.

The only real way to protect yourself as an investor is to educate yourself. There is literally no substitute for this. Challenging as it may seem to some readers, that means getting down and dirty with the shadowy world of economic data.

Some of you will immediately want to switch off at this point. Don’t. What follows is critical to your financial future, because it allows you to differentiate between good, murky, and unreliable economic data. (Hat tip, Chris Martenson of ChrisMartenson.com)

Into the good bucket I put all sources of data fitting the following important criteria: The data itself is not statistically massaged before release, it is not ’sampled’ but rather tallied up in its entirety, and it squares up nicely with other good sources of data.

Good Data

• Sales tax data
• Income tax data
• Truck tonnage moved
• Port shipping container traffic
• Air transport
• UPS, FedEx, and other major shippers’ volume
• Corporate Revenues (just added to list )

Into a bucket of lesser importance goes the murky data. This data is based on sampling, usually conducted by self-interested parties (National Association of Realtors data for example), or is seasonally or statistically adjusted, and/or does not square up with other, better data.

Murky Data

• NAR home sales data
• Continuing claims
• Retail sales data
• Trade deficit reports
• Corporate Income (just added to list )

Into the final bucket goes the utterly unreliable ‘data’, so bad that I need to use quotes around it. This ‘data’ is modelled or otherwise manufactured out of thin air with no accountability, does not square up (at all) with good sources of data, has massive errors in methodology that have never been explained … is self-referential (e.g. LEI or ‘leading indicator’ data), and/or has been proven repeatedly in the past to be consistently biased for political or self-serving gain.

Unreliable Data

• New home sales data
• Employment data (due to the Birth-Death model)
• All survey data
• Leading indicator data
• GDP (just added to list )

To be clear, we’re highly sceptical here at Notes of the rally on Wall Street. In our opinion, it stinks. That’s why we recently sold all our long positions in US stocks.

The reasons for our suspicions are pretty easy to follow. Sooner or later investors are going to wake up to the fact that the economy and corporate profits are in the ditch.  And there’s only so much optimism you can squeeze out of “better than expected” but still thoroughly crappy results.

As we said here at Notes last week, earnings forecasts are routinely “low balled.” The reality, no matter which way you look at it, is that corporate profits are down 31% from their already recession-ravished levels of a year ago.

Does this mean we may miss out on the beginning of a genuine bull run? Absolutely. But we’d rather miss out on the first 20% of a bull run than get suckered by a collapsing bear market rally.

Let’s be clear about this. We don’t expect a genuine reversal of this secular bear until the unemployment picture improves. No jobs = no spending = no profits. The government can ‘stimulate’ all it wants. But it can’t force people to spend money they don’t have.

As our favorite analyst, David Rosenberg, pointed out on Friday, and as we warned Notes readers last week, the US stock market is now following a near identical pattern to the 1929/1930 bear market rally. The correlation between the two chart patterns is a staggering 80%.

The 1929/1930 rally lasted just over 100 days from the 1929 trough before taking a dive. We are now at the same distance from the March 9, 2009 low of 666 on the S&P 500. If history repeats itself, we are in for another stomach churning leg down.

Investors shouldn’t be surprised that equities rally in a secular (long term) bear market; they often do. As Rosenberg puts it, “The problem with secular bear markets is that they are quite often punctuated by sharp upward spasms that can last months or even quarters.”

As Notes faithful will know, we pinned our colors to the inflation mast some time ago. It is a clear-and-present danger. Especially considering that the feds have no way of paying off their massive debts without triggering an inflationary episode.

But underground investor Tom Dyson says when it comes to the prices of goods and services now, deflation is the name of the game.

Timing is everything in the investment world, of course. And knowing that inflation is on its way is no good to anybody unless they have a reasonable chance of knowing when the tide will turn. And considering Notes is first and foremost about money-making ideas, we’ve decided to hang up our inflation boots for a while and pass on one of the best deflation plays we’ve seen all year.

Unfortunately, it’s too late to reverse course for America. President Obama’s spending program is speeding up the collapse, not slowing it down. Right now, 21 cents out of every $1 paid over to the feds in income tax goes to paying off the interest on the national debt. Soon, it will be almost double that amount. It doesn’t take a genius to work out that this is unsustainable.

It doesn’t take a genius, either, to figure out that higher spending and higher debt mean higher taxes and a weaker dollar. Here are just some of the shocking forecasts James makes in this explosive report:

• No matter who you are, your taxes will go up. The government will continue to raise taxes in an attempt to keep its spending programs alive. The Obama administration is already planning to raise corporate taxes, already the second highest in the world. The costs of this will be passed on to you whenever you buy something.
• The US dollar is already being undermined as the world’s reserve currency as US debt holders led by China, Russia, India and Brazil move to protect themselves against dollar depreciation. Soon the dollar will lose its reserve currency status.
• The Social Security Ponzi scheme will collapse. The government will be unable to borrow the funds it needs to replace all the money it has already spent from the Social Security trust fund.
• Interest rates in the U.S. will rise to 6% plus as the government needs to raise the rate to stimulate foreign demand.
• Excessive government borrowing will push up mortgage rates and trigger another leg down in the housing market. Huge numbers of prime borrowers have already begun to default on their mortgages, triggering what is destined to become another wave of toxic asset writedowns at banks.
• The government will default on Social Security payments and Medicare and Medicaid obligations. It will not do so in an open way. Instead, it will fail to accurately index-link Social Security benefits to the cost of living… it will ration hospital stays and doctors visits… and it will deny expensive treatments and medication to state-insured patients (beginning with the elderly)
• The US will enter a long period of economic stagnation coupled with inflation.
• In years to come, the period between 2008 and 2018 will be known as America’s “lost decade.”
• Oil prices fall to $25 a barrel before breaking through their July 11 2008 high of $147.90 a barrel.
• Unemployment rates will rise to 20%.

James is a personal friend. And he’s one of the best thinkers about the global economy we know. Back in 1993, James sent out a similar warning to investors. His forecasts, 14 years before the subprime collapse was ever heard of, were scarily accurate…

· I see at millions unemployed or in make-work public assistance jobs.

· I see millions more homeowners “upside down” – with a mortgage bigger than the value of the home.

· Banking industry problems will prove too big for the government to paper over.

We strongly urge you to read James’s latest report. Of course, he could be wrong. The nearly $12 trillion national debt could just keep on growing to infinity with no serious repercussions for America’s economic standing in the world. The breakneck increase in the money supply since the outbreak of the economic crisis may not trigger a dangerous inflationary cycle. And President Obama might pull a white rabbit out of a top hat instead of increasing taxes to pay for his bloated budget. But we doubt it. As we like to say here at Notes, “Smart investors hope for the best, but they prepare for the worst.”

The Congressional Budget Office (CBO), the non-partisan federal agency responsible for providing economic data to Congress, knows the game is up, too. This from the CBO’s director’s blog:

Under current law, the federal budget is on an unsustainable path, because federal debt will continue to grow much faster than the economy over the long run. Although great uncertainty surrounds long-term fiscal projections, rising costs for health care and the aging of the population will cause federal spending to increase rapidly under any plausible scenario for current law. Unless revenues increase just as rapidly, the rise in spending will produce growing budget deficits. Large budget deficits would reduce national saving, leading to more borrowing from abroad and less domestic investment, which in turn would depress economic growth in the United States. Over time, accumulating debt would cause substantial harm to the economy. […]

Keeping deficits and debt from reaching these levels would require increasing revenues significantly as a share of GDP, decreasing projected spending sharply, or some combination of the two.

We believed in Santa as a kid. But we don’t believe that Team Obama is going to decrease spending “sharply” or otherwise. So “revenues” (aka taxes) will have to rise.  And to soften the blow, you can count on the administration reneging on its Social Security and Medicare obligations.

What Barack Obama and Joe Biden just don’t get is that too much taxation drove the American Revolution. And with the federal government now consuming about 28% of GDP and state and local governments another 15%, tax hikes are inevitable. In fact, they are already here. This from well-known fiscal conservative Pat Buchanan:

Obama plans to repeal the Bush tax cuts and take the income tax rate to near 40%. Combined state and local income tax rates can run to 10%. For the self-employed, payroll taxes add up to 15.2% on the first $106,800 for all wages of all workers. Medicare takes 2.9% of all wages above that. Then there are the state sales taxes that can run to 8%, property taxes, gas taxes, excise taxes and “sin taxes” on booze, cigarettes and, soon, hot dogs and soft drinks.

Comes now national health insurance from Nancy Pelosi’s House. A surtax that runs to 5.4% of all earnings of the top 1% of Americans, who already pay 40% of all federal income taxes, has been sent to the Senate. Included also is an 8% tax on the entire payroll of small businesses that fail to provide health insurance for employees.

One thing you can be sure of is that the world’s economic mandarins are slow to learn from the mistakes of history. This from the Daily Reckoning:

After the expansion comes the contraction. After the bubble comes the clean-

up. After the storm comes the sun.

But what is going on in China? What comes after the biggest export-led
bubble ever? Another bubble?

It doesn’t seem possible. China’s number one customer is broke. It has far too
many factories for those that are left. It should be closing up shop…and
waiting out the bad weather. And yet, China is growing. A combination of hot
money…and hot financial policy…is falling on everyone’s favorite green shoot
like Miracle-Gro. Its trade surplus and foreign direct investment – the usual
source of reserves of foreign currencies – are only half what they were last
year. But the speculators are coming in…and they are bringing cash. This has
boosted Chinese reserves past the $2 trillion mark…and provided the liquidity
for another round of bubble-like conditions. Trading volumes in Chinese
stocks, for example, are running three times last year’s.

The world’s investors and economists think they are looking at the Second
Coming. Chinese growth will power the world out of its slump.
Hallelujah…we’re saved! Things will be ‘back to normal,’ soon. Stocks rose
yesterday in anticipation – with the Dow up.

Daily Reckoning readers are warned: this too shall pop.

Our faith is weakening. That is, our faith that the government will be able to cause inflation, sooner or later. Let’s review our own narrative: deflation now, inflation later.

Politics is not about what works, it’s about what you can get away with. And what you can get away with is often exactly what doesn’t work at all.

Our beat is money, here at the Daily Reckoning. We specialize in fraud and folderol. We leave the homicide beat to someone else.

What the US is getting away with, from a financial point of view, in addition to counterfeiting, is very grand larceny on a Super-Madoff scale. It is borrowing trillions of dollars even though it has no way to honestly pay back the money.

Still, so eager are the lenders to part with their money that the yield on the 10-year T-note fell yesterday to 3.64%. The more the feds borrow, apparently, the more lenders are willing to lend.

We’re in the Third and Fatal stage of a great country – the political stage. In this stage, money and power migrate from the financial community to the political community. The politicians get away with taking trillions out of the productive economy and spending them on their pet projects and private corruptions.

Warren Buffett described the America of the Bubble years as “Squanderville.” Private citizens were living beyond their means, he pointed out. But he hadn’t seen nothin’. Now, the squandering is done by government. The politicians are spending trillions they don’t have on projects nobody was willing to pay for even when they had some money in their pockets.

What the government can get away with now – under cover of a financial crisis – is a big grab for money and power. It ‘works’ in the sense the feds are able to get away with it. But it will prove fatal to the dollar… and to the US economy.

We will return to that subject below…

Back in the markets, the Dow fell modestly yesterday, down 16 points. Oil clung to the $69 level. Gold was up $3 to $924. And the dollar saw its biggest drop in weeks as speculators waited for word from the Fed on its next move.

The Fed is expected to talk about an “exit strategy.” It is intervening in markets as no Fed ever has. Its balance sheet – a measure of how much intervention it has done – has shot up in a way that is not only unprecedented, but almost unbelievable. In an effort to provide liquidity, it has bought up the contents of every neglected refrigerator on Wall Street. The smelly, furry stuff – “toxic” derivatives… SIVs… MBAs… no one seems to know exactly what it is – enters the Fed’s books as an asset. Altogether, along with its not-so-pungent holdings of US Treasury bonds, the Fed’s balance sheet shows more than $2.7 trillion worth of assets.

What happens next?

We don’t know. But it is far too early to worry about it. The Fed is in no position to head for the exit. It will have to stay on this road for much, much longer.

Why? Because the “green shoots” are shrivelling up. There is no real economic revival. And there can’t be one until the underlying problems are corrected.

One of the big problems is too much capacity. We mentioned it yesterday. During the Bubble Epoque the squanderers would buy anything. So, you could make an almost unlimited amount of money by providing them with things to buy. This meant building factories… buying trucks… and renting retail space. Now, however, the squanderers have come to their senses. They want to save their money. So, no need for so much retail space in the malls, so many trucks on the highways or so many factories in China.

America’s middle class has rediscovered thrift.

There are a number of sit-down restaurant chains that cater to the middle class – Applebee’s… Chili’s… Ruby Tuesday and a few others. They expanded greatly during the ‘90s and ‘00s in order to meet the desires of the big spending masses. But now that the masses aren’t so free and easy with their money, New York Times reports that they are in desperate competition for remaining diners. This competition is manifesting itself as price deflation.

Applebee’s offers dinner for two for only $20. Chili’s advertises entrees (the main course in America) for just $7. Ruby Tuesday’s is going for a 2-for-1 deal. Buy one meal, get one free. All of them are making heavy use of discount coupons.

Oversupply is producing deflation. Prices are falling as suppliers fight for demand by offering more for less. And over at the Red Roof… the roof has already caved in as the chain has defaulted on its mortgage debt.

This is what you’d expect at the end of a long period of credit expansion. EZ credit brought forth too much demand and too much supply. Now, the demand is disappearing… and the suppliers struggle to hold on.

This is natural, normal and perhaps necessary to a market economy. And it will take years to sort out. Roofs have to fall in on thousands of enterprises, speculators and households. Then, the rebuilding can begin.

But the Bernanke Fed is not about to let nature take her course. The Fed is on the road to ruin… and it’s not about to “exit” yet. Deflation is still enemy number one. Don’t expect any tightening from the Fed anytime soon, dear reader… it is far too soon for that.

*** More news from Manraaj Singh on why “captains of industry” are furiously selling out of shares in the companies they run.

“Insiders are selling-out. Investors have increasingly reached the point where they been questioning the sustainability of the rally.

“The signs of a coming sell-off have been rising sharply recently. Share valuations in both emerging and developed markets have reached unsustainable levels. And another key indicator of a coming market correction has been the scale of insider selling within the big US companies. This is a measure of whether the top managers of publicly-listed companies have been buying or selling shares in the companies that they run. And the data has not been good.

“So far this month, company insiders in the US have sold 22 times more shares than they have bought. In other words, the majority of people who run listed companies in the US just don’t consider their own companies worth investing in right now. The data for June, up to now, shows that insiders of S&P 500 listed companies have sold $2.6 billion in shares, compared with just $120 million in purchases.

“This is a very important clue as to where markets are heading. Because the last time there were more U.S. corporations with executives reducing their share holdings than adding to them was during the week that ended 19th June 2007. Global stock markets went into meltdown shortly after that. I expect to see the same thing happen over the next couple of weeks.

“Right now, the chaps with ring-side seats of the US economy see plenty more pain head. And as the US economy goes, so goes the world economy… ”

Editor’s note: Manraaj Singh believes the sell-off is a good thing for long-term investors. The sharper the falls, the cheaper the price at which we can get into the investments that we want. Manraaj is Chief investment strategist of Profit Hunter, which looks to profit from special situations around the world. To learn more about his service and discover his latest investment recommendation, click here.

And more thoughts… .

*** Governments are essentially parasites on productive activity. So the best governments are the smallest – meaning, the least parasitic. “The government with governs best governs least,” is how Jefferson put it.

But now we are in the third and fatal stage of a great country – the political stage. In this stage, the parasites take over. Government governs a lot. And governing a lot costs a lot of money. In England, the government budget is bumping up against half the total GDP of the nation. In America, health care is still largely a private matter, so the government spends a smaller percentage of GDP… but it is a percentage that is rising quickly.

Where will the money come from? Taxes. Gordon Brown has already put the income tax rate up to 50%. Michael Caine, an English actor who moved to California to escape the high taxes of the ‘70s, says he will tolerate 50%… but not a penny more.

“If it goes to 51% I will be back in America,” he says.

Ahem… he might have to try somewhere else. Everybody’s gunning for the rich – in America as well as England. Obama has pledged to raise taxes on the rich. The states, notably California, are desperate for more revenue too. Add federal, state and local levies… and private health care costs… and you could easily be over the 50% bracket in America too.

But when you rob the productive Peters to pay the parasite Pauls two things happen. The Peters get their backs up. And you’ve soon cleaned them out anyway.

So, governments need to find other sources of financial support. Typically, they borrow money.

The history of European monarchies is largely a history of debt. Kings and queens squeezed what they could out of the turnips. Then they turned to the moneylenders. These lenders had to be careful. They were happy to extend monarchs credit, because in this way they gained a measure of control over them. But there were many dangers.

Kings lost their heads… or went broke. Or, often, the monarchs could turn the tables on the moneylenders… and have their heads cut off. Reading the history of the loans to the French crown it is eye-opening. It is amazing anyone wanted to lend at all. The risks were great; the rewards were few. Rarely were the loans settled honorably.

What you come to see is that lending to the government – which always has the power to betray the loan and behead the lender – is merely another form of taxation. Government raises money. Sometimes it repays the loan with revenues from other taxes. Sometimes, it is the lender who pays the tax himself – either because the government defaults… or because inflation reduces the value of his money.

This week… indeed, this year… lenders are turning over massive amounts of money to the US government. There is so much demand for US paper that the yield on the 10-year note fell yesterday to 3.64% – despite the huge new supply of T-notes coming on the market. It is breathtaking to watch. But it is a story that will end badly. We predict that lenders will end up like the financiers who lent to Louis XIV and later regretted that they ever met the man.

“Every loan always diminishes the free revenue and necessitates, at the end of a certain time, either bankruptcy or the increase of taxes,” explained Turgot to a later Louis. “In times of peace it is permissible to borrow only in order to liquidate old debts, or in order to redeem other loans contracted on less advanta¬geous terms.”

Any borrowing in excess of that puts you on the road to ruin, Turgot went on to explain.

More on Turgot – a man sadly neglected by historians – in upcoming reckonings.

Source:  Grand Larceny on a Super-Madoff Scale

JPMorgan Chase & Co. and American Express Co. were told they need to boost common equity, less than four weeks after being informed they had enough to withstand a deeper economic slump. Morgan Stanley was directed to raise more funds after already selling stock to cover its stress-test shortfall. One firm was told June 1, people with direct knowledge said.

This means two things. 1) That the government’s stress tests were indeed a sham designed to coax investors back into bank stocks. 2) That the government expects more pain for the banking sector and isn’t prepared to have banks get out from under the TARP only to come back begging for federal aid at a later date.

As former New York Fed executive vice president pointed out recently, if banks repay TARP funds next week, “politically, the administration can claim a victory. They can claim TARP is working, we’re getting our money back and making a profit. But there are more shoes to drop in commercial and industrial loans, leveraged loans, and real estate.”

As we have attempted to make clear all along in Notes , this crisis boils down to a battle between hope versus facts. You know which side Team Obama and the mainstream press is on. And you know which side we’re on.