It’s very simple. Maybe too simple. After a half a century of credit expansion, we now have a credit contraction. In this sense, everything is happening as it should.

There was a crash and credit crunch at the end of last year. Then, the feds panicked. They fought back with monetary and fiscal stimulus. Rates were cut to nearly zero. The Fed flooded the system with cash and easy credit – buying up Wall Street’s bad investments…propping up bad banks…and guaranteeing trillions worth of bad debt. And the federal government passed a stimulus program that authorized more than $700 billion in spending.

Beginning on March 9th, we also got a big bounce in the world’s stock markets – just as we should. US stocks are up about 40% since then. Some foreign markets are up even more. Russian stocks, for example, have more than doubled. Chinese stocks are up more than 60%.

As the bounce continued, people began to get the wrong idea. They thought they saw ‘green shoots’ and the ‘light at the end of the tunnel.’ But if the economy is really improving, we haven’t seen much evidence of it here at The Daily Reckoning headquarters. As near as we can tell, housing prices are still going down and unemployment is still going up…and most important…people are still acting as though we were on the downward slope of the credit cycle. The latest numbers we’ve seen show that they saved more money in the first half of the year than the total in extra ‘stimulus’ that they received. Savings – last reported at 5% in this space – are now close to 7%. This is a just what you’d expect. But it is a huge turnaround, too.

As to housing prices, there are a million option ARMs still to be reset over the next four years. They won’t peak out until 2011…with average increases of about 80%. That will cause hundreds of thousands more houses to be dumped onto the market…and probably push the bottom of the housing decline to 2012.

As long as housing prices are falling, jobs are declining, and consumers are inclined to save rather than spend, there will be no real recovery.

In our book, recovery is impossible anyway. Because the pre-crisis economy had reached the terminal stages of the credit cycle. It was like someone in the terminal stages of a fatal illness. After they have died, you don’t wish that they could recover…and be just like they were before they died. They were sick and dying then! No, you sign the book of memories and condolences and turn the page. You let new life take the place of the dead. You move on.

But the feds have their ghoulish agenda. They have the poor thing on life-support. One tube feeds the oxygen of easy credit. Another drips in more ‘stimulus.’ The economy rattles every time it breathes. Dead companies, such as GM, say they are reborn. But take away the tubes…and they collapse. Dead-in-the-water households learn to live submerged in debt …with special tubes provided by the feds – such as the underwater mortgage refinancing offered by Fannie and Freddie, where homeowners can get up to 125% of the value of their houses. And the brain dead economists at the Fed and the Treasury department continue to offer their elixirs and panaceas – even though they have never worked.

Everything is happening as it should, in other words. But what happens next?

Ah…this is where it gets tough. Because we’re losing our faith. We figured the economy would continue to worsen (after all, you can’t correct a half-century credit expansion in a few months)…and that the feds would continue to fight it. As more and more people lose their jobs, the feds would become more and more desperate. Gradually, they’d come to see that they needed to use stronger, more experimental techniques. This would lead them to be a bit bolder with their ‘quantitative easing,’ otherwise known as “a little technology called the printing press,” to quote Ben Bernanke.

We figured that sooner or later, the feds would get the hang of causing inflation. So, we could just buy gold and wait.

But now we see; we are trapped…just like the feds themselves. Do we hedge against further economic deterioration…deflation…and falling asset prices? Or do we hedge against inflation…a falling dollar…and a collapsing bond market? What if we hold our big position in gold…and feds NEVER are able to cause inflation? What if the pain of the depression is never severe enough to make them go whole hog on quantitative easing? What if the Chinese put it to them straight: if M2 goes up more than 10% a year…we stop financing your deficits? Gold could sink…or go nowhere…for the next 10 years.

Are we prepared to sit it out…? It’s time to go back to the pub…

This morning our thoughts turn to Goldman.

The news yesterday told us that Goldman execs paid themselves $700 million in bonuses – while receiving bailout money. This morning, stocks in Asia are rising; they say it’s because Goldman had a good quarter – wiping out its loss from the last quarter of last year…

The news:

“Goldman Sachs reported second quarter earnings of $2.72 billion, up on last year’s $2.05 billion, and easily surpassing forecasts thanks to big gains in trading and underwriting.”

The New York Times offers more details:

“Analysts estimate that the bank will set aside enough money to pay a total of $18 billion in compensation and benefits this year to its 28,000 employees, or more than $600,000 an employee. Top producers stand to earn millions.

“Goldman Sachs is betting on the markets, but the markets are also betting on Goldman: Its share price has soared 68 percent this year, closing at $141.87 on Friday. The stock is still well off its record high of $250.70, reached in 2007.

“In essence, Goldman has managed to do again what it has always done so well: embrace risks that its rivals feared to take and, for the most part, manage those risks better than its rivals dreamed possible. “For all its success, Goldman is not impregnable. In addition to the federal money it took last fall, it benefited from the government’s bailout of the American International Group, being paid 100 cents on the dollar for its $13 billion counterparty exposure to the insurer, and it has $28 billion in outstanding debt issued cheaply with the backing of the Federal Deposit Insurance Corporation.”

Not everybody likes a winner. There are some who think there is something underhanded and un-American about how Goldman does business. Making billions trading bonds? It is almost as if they knew better than anyone else what the feds would do next. Maybe they do.

The DR Australia’s Dan Denning offers his two cents on the subject:

“We’d suggest that whatever Goldman did to goose earnings is probably not going to be possible for the rest of corporate America.” Furthermore, Denning points out, most other American financial institutions are continuing to play “hide the bad asset.”

“A New York Times story suggests that government capital injections and loan guarantees, along with new equity offerings, have allowed banks to evade the inevitable consequences of the popped credit bubble.

“‘The capital provided by the government through TARP, etc. has allowed the banks to continue holding deteriorated assets at values far in excess of their true market value,’ says Daniel Alpert of Westwood Capital in a note to clients, according to the Times. ‘It is unrealistic to believe that home or commercial real estate values are destined to recover any meaningful portion of bubble-era pricing.’

“This means all the new equity raised by banks after the stress-tests has merely papered over capital adequacy and solvency issues for now,” Denning continues. “The banks have simply refused to revalue loans on their books and continue to carry them at unrealistically high valuations. If they sold them, they’d get a lot less for them, forcing them to raise more capital (or wiping out their capital and revealing them to be insolvent)…

“The default and foreclosure data coming out of the US housing market suggest the banks are kidding themselves, or misleading shareholders, or both!” says Denning. “It’s the sort of calculated mistruth that can cause a short-term crisis to last years and years. The correction is postponed through phony accounting. It leads to an ‘Ushinawareta Junene,’ or ‘lost decade,’ as the Japanese say.”

Source:  An Economy on Life Support