It’s true; gold has become noticeably less unpopular during the last few months. It is still not as popular an investment as, say, AIG or the shares of almost any other incompetent financial institution. But some investors have actually begun to admit that they’ve purchased some gold.

A couple of the most conspicuous gold-buyers – the Chinese government and hedge fund manager, John Paulson – represent quintessential examples of the “new” gold buyer. This new type of buyer does not also buy ammunition, bottled water and Lynyrd Skynyrd tank tops. Nor does this new gold buyer spend Saturday nights sipping Gallo Hearty Burgundy in his La-Z-Boy, while flipping through binders full of Walking Liberty gold coins.

These new gold buyers do not LOVE gold nearly as much as they FEAR paper. But they are buying aggressively nonetheless…and leaving their tracks everywhere.

Earlier this year, for example, Paulson & Co., the hedge-fund firm run by billionaire John Paulson, became the largest holder of the SPDR Gold Trust (NYSE: GLD), an ETF that buys gold bullion. The New York-based firm owned 8.7 percent of the fund, as of March 31. Paulson has also taken very large stakes in several gold mining companies – in particular Gold Fields Ltd. (NYSE:GFI), Kinross Gold Corp. (NYSE:KGC) and AngloGold Ashanti Ltd. (NYSE:AU)

Paulson has lots of company among mom and pop investors who are allocating some of their capital to gold. As the nearby chart illustrates quite clearly, the SPDR Gold Trust ETF has been accumulating ever-rising quantities of gold bullion – all in response to investor demand.

Although this chart is a bit dated, the trend it illustrates remains firmly entrenched. As of September 21, this ETF controlled 1,563 tonnes of gold, making it the world’s fifth individual holder of gold. The Swiss central bank, by comparison, holds only a little more than 1,000 tonnes of gold.

Meanwhile, the Chinese doubled their official gold holdings last year, and have been making a lot of headlines with some very public gripes about the dollar. A couple weeks ago, Cheng Siwei, former vice chairman of the Standing Committee of the Chinese Communist Party, complained, “If [the Fed] keeps printing money to buy bonds, it will lead to inflation, and after a year or two, the dollar will fall hard. Most of our [Chinese] foreign reserves are in U.S. bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen and other currencies…Gold is definitely an alternative.”

No wonder rumors were running rampant last week that the 403 tonnes of gold the IMF is selling will land in a Chinese vault.

Interestingly, while investment demand for gold inexorably rises, mined production of gold inexorably declines. Apparently, the folks who coax this precious metal from the earth can’t coax as much of it as they might like.

According to Grant’s Interest Rate Observer (citing statistics from the World Gold Council), worldwide gold production has dipped over the last seven years. Gold production since 2002 has declined from 2,590 metric tons to 2,486 metric tons through June 30.

These divergent trends – demand up and supply down – do not guarantee a rising gold price, but they do suggest that a rising gold price may become the path of least resistance.

Obviously, substantial above-ground supplies of gold – in bank vaults, around fingers, in belly buttons, etc. – will find its way into the gold market if/as/when prices rise. Nevertheless, a powerful inflationary trend would produce enough investment demand for gold to easily absorb all sources of supply…and ALSO push the gold price higher.

“There is a growing distrust of paper currencies amid a deluge of massive government deficits since late 2008,” Roseman concludes. “The dollar might be the biggest drunk at the bar, but the euro and other currencies are also drinking their way to devaluation against gold.”

Source: The New Gold Buyer

It’s true; gold has become noticeably less unpopular during the last few months. It is still not as popular an investment as, say, AIG or the shares of almost any other incompetent financial institution. But some investors have actually begun to admit that they’ve purchased some gold.

A couple of the most conspicuous gold-buyers – the Chinese government and hedge fund manager, John Paulson – represent quintessential examples of the “new” gold buyer. This new type of buyer does not also buy ammunition, bottled water and Lynyrd Skynyrd tank tops. Nor does this new gold buyer spend Saturday nights sipping Gallo Hearty Burgundy in his La-Z-Boy, while flipping through binders full of Walking Liberty gold coins.

These new gold buyers do not LOVE gold nearly as much as they FEAR paper. But they are buying aggressively nonetheless…and leaving their tracks everywhere.

Earlier this year, for example, Paulson & Co., the hedge-fund firm run by billionaire John Paulson, became the largest holder of the SPDR Gold Trust (NYSE: GLD), an ETF that buys gold bullion. The New York-based firm owned 8.7 percent of the fund, as of March 31. Paulson has also taken very large stakes in several gold mining companies – in particular Gold Fields Ltd. (NYSE:GFI), Kinross Gold Corp. (NYSE:KGC) and AngloGold Ashanti Ltd. (NYSE:AU)

Paulson has lots of company among mom and pop investors who are allocating some of their capital to gold. As the nearby chart illustrates quite clearly, the SPDR Gold Trust ETF has been accumulating ever-rising quantities of gold bullion – all in response to investor demand.

Although this chart is a bit dated, the trend it illustrates remains firmly entrenched. As of September 21, this ETF controlled 1,563 tonnes of gold, making it the world’s fifth individual holder of gold. The Swiss central bank, by comparison, holds only a little more than 1,000 tonnes of gold.

Meanwhile, the Chinese doubled their official gold holdings last year, and have been making a lot of headlines with some very public gripes about the dollar. A couple weeks ago, Cheng Siwei, former vice chairman of the Standing Committee of the Chinese Communist Party, complained, “If [the Fed] keeps printing money to buy bonds, it will lead to inflation, and after a year or two, the dollar will fall hard. Most of our [Chinese] foreign reserves are in U.S. bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen and other currencies…Gold is definitely an alternative.”

No wonder rumors were running rampant last week that the 403 tonnes of gold the IMF is selling will land in a Chinese vault.

Interestingly, while investment demand for gold inexorably rises, mined production of gold inexorably declines. Apparently, the folks who coax this precious metal from the earth can’t coax as much of it as they might like.

According to Grant’s Interest Rate Observer (citing statistics from the World Gold Council), worldwide gold production has dipped over the last seven years. Gold production since 2002 has declined from 2,590 metric tons to 2,486 metric tons through June 30.

These divergent trends – demand up and supply down – do not guarantee a rising gold price, but they do suggest that a rising gold price may become the path of least resistance.

Obviously, substantial above-ground supplies of gold – in bank vaults, around fingers, in belly buttons, etc. – will find its way into the gold market if/as/when prices rise. Nevertheless, a powerful inflationary trend would produce enough investment demand for gold to easily absorb all sources of supply…and ALSO push the gold price higher.

“There is a growing distrust of paper currencies amid a deluge of massive government deficits since late 2008,” Roseman concludes. “The dollar might be the biggest drunk at the bar, but the euro and other currencies are also drinking their way to devaluation against gold.”

Source: The New Gold Buyer

“If they [the Fed] keep printing money to buy bonds,” said Mr. Cheng, “it will lead to inflation, and after a year or two, the dollar will fall hard. Most of our [Chinese] foreign reserves are in US bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen and other currencies.” Mr. Cheng was referring to over $2 trillion of Chinese foreign reserves, the world’s largest holding.

“Gold is definitely an alternative,” said Mr. Cheng, “but when we buy, the price goes up. We have to do it carefully so as not to stimulate the market.”

From Mr. Cheng’s lips to God’s ears – and now to ours. We have direct testimony from a high-level cadre that China, while cautious, is a key driving force in the gold market. China is buying.

We already knew that the Chinese are buying gold – and hoarding it. For example, China is the world’s largest gold-mining nation. China mines more gold each year than the US or South Africa. Yet what are the net gold exports from China? Umm…zero. That is, China doesn’t export gold (unless you buy a Panda coin or something.) Overall, in fact, China is a net importer of gold.

Sure, the Chinese use gold in industry, such as for electronics, jewelry and the like. But much of the rest of Chinese gold purchases go into state coffers, or into “off-books” storage. I’ll bet that there’s a lot of gold in “industrial stockpiles” in China, which are really just strategic monetary reserves for China’s Central Bank.

The implication from Mr. Cheng is that the Chinese will not overbuy gold, which may be why the yellow metal has hovered just below the $1,000 mark per ounce in recent weeks. At the same time, it’s more than likely that China will buy gold whenever there’s a price dip.

The significance is that the Chinese seem to be prepared to establish a floor under any correction in gold prices. This limits the downside for well-positioned gold miners such as we hold in the Energy & Scarcity Investor portfolio.

Is there an upper limit to gold prices? Well, I expect to see the gold price rise, but slowly and in a long series of plateaus. I also expect to see pullbacks, usually based on world monetary and political events.

So we’ll surely have some roller-coaster rides with the prices for the mining shares. How it all unfolds for us as investors will depend on when, and to what degree, monetary-driven inflation begins to bite into the economy. When it becomes totally obvious, it’ll probably be too late to protect and preserve your wealth and purchasing power.

The problem for us in the West is that most of the politicians and major media just DO NOT GET IT. Or at least, the ones that do “get it” generally don’t report things honestly to the citizens. They’re probably afraid of what might happen when the citizens really figure out how much the political classes have screwed up the world.

So you see these rosy-sounding headlines about how the economy is “improving” and things are “getting better.” Huh? What planet are these guys on?

The tide of inflation is rolling in. It’ll lift the boats of the gold miners.

Regards,

Byron W. King

Source: A Floor Beneath the Gold Price

The downturn took $12 trillion off Americans’ net worth. The feds have pledged about $12 trillion to fix the problem.

But wait, where does government get any money?

Hey, they borrow it, just like consumers did. And besides, it’s ultimately the same money – taxpayers’ money. So what’s the big diff?

The big diff is the subject of today’s Daily Reckoning.

The first big diff is that the feds don’t spend your money the way you would. Private citizens spend money they don’t have on things they want but don’t need. The feds spend money that doesn’t belong to them on things that the rightful owners don’t even want.

Wait a minute. US markets were closed yesterday for Labor Day. With no figures to report, we should talk about something important. What’s important about macro-economics? Nothing. It’s 95% claptrap. The other 5% is pure fraud.

At least as practiced by the leading macro-economists of our time – such as Ben Bernanke, Tim Geithner and Larry Summers. It’s just a show-off sport… the idea is to impress the world with some fancy data-heavy formula… win the Nobel Prize and save the world. That way, you get what all men crave… money and power. Why do men (and women) want money and power? Aw c’mon… we explained it already. Because it improves their chances of survival and procreation. In a DNA study, for example, they found that Genghis Khan, today, has something like 6 million male descendants. Is that success, or what?

The great Khans of today are no longer the steppe warriors on horseback. They’re basketball players, rock ‘n’ roll stars, actors, and hedge fund managers. And, oh yes, occasionally, economists.

The link between economic theory and procreation is probably very weak; but that doesn’t stop economists from wanting to strut around and show off. And the way for an economist to show off is to get himself appointed to the President’s Council of Economic Advisors… or to the central bank… or get a professorial post at Princeton… etc. etc. This you do by producing tomes, formulae and hypotheses. And, don’t forget to write a piece for the Wall Street Journal from time to time.

Another important hint: your work has to suggest that you can manipulate the business cycle, control the credit cycle, or generally make things turn out the way people want.

If you are a Daily Reckoning-type economist, you can forget fame and fortune completely. Who wants to hear from a macro-economist who tells people to leave well enough alone… and to let the forces of natural economics sort out their own problems? No one… at least no one who is running for public office. Instead, they want someone who will promise to “Save the World.”

Save the world from what? Why… from the damage done by other economists!

Two generations of American economists thought the way to bring prosperity was to encourage consumption. On the face of it, the idea is absurd. Classical economists… and Daily Reckoning commentators… laugh at the idea. You don’t really get rich by consuming; you get rich by saving and investing.

But they had their charts and graphs… their theories and their jobs teaching economics at prestigious universities. Naturally, they had the feds’ ears too – since every politician wants to promise more consumption. The feds favoured home ownership, for example… even by people who were bad credit risks. They set up Fannie (NYSE:FNM) and Freddie (NYSE:FRE) to make it easy for people to buy houses. They even passed a law requiring banks to lend to people who weren’t likely to pay them back; that was the origin of the sub-prime mortgage market! They kept interest rates low, too, so people could borrow at affordable rates. And they inflated the currency, so consumers would want to spend their money rather than save it. They also opened the world to free trade, so Americans could buy more, cheaper stuff made by foreigners. For 50 years, they cultivated consumption and let production go to seed.

And now… wouldn’t you know it… Americans have over-consumed. Personal expenditures per capital rose 25% between 2003-2005. Personal debt soared to over $13 trillion… about $124,000 per household. Total debt/GDP tripled since 1980.

And now it’s pay-back time. The private sector has cut back. Consumers need to under-consume to make up for the over-consumption of the bubble years. Savings rates are rising. Spending is falling (see below)…

And so what do the simpletons do? Private citizens are unwilling to consume… so they push the government to consume their money for them!

“Frugality is the new normal,” says an Associated Press report. One study suggests that consumer will spend 14% less – even AFTER the recession is over.

Boomers are out of time. Out of money. And they’ll be out of luck unless they trim expenses and begin saving.

They’ve figured it out. Personal spending has fallen in 4 of the last 6 quarters. It hasn’t done that since 1947 – when they first began tracking it.

Consumers’ net worth has taken a big hit – down $15 trillion, from $65 trillion to $50 trillion.

And so, the simpletons think the government has to rush in where fools foundered… that is, rush in with more money.

But where do the feds get any money? They have to borrow it… or print it. There’s a big difference between federal borrowing and private borrowing. When the private sector borrows the risk is that people won’t be able to pay back their loans. That is a risk that lenders live with. They know the risk; they factor it into their decision-making. Sometimes they’re right. Sometimes – such as when economists mislead them with a lot of gibberish numbers – they’re wrong. And when they’re wrong, borrowers default… and lenders lose money.

The feds, on the other hand, can’t default. At least, not when their debts are calibrated in money they control. But there’s the risk right there. And it is a different kind of risk. It’s the risk that the feds may choose to pay back the loan in much cheaper currency. Or merely make a mistake that results in much cheaper currency.

Imagine a private borrower who could print up a few extra bills in his basement to pay his monthly mortgage. He may not do so… perhaps his sense of honour would prevent him. Or maybe he would fear that he wouldn’t be allowed to borrow again. But if his back were to the wall, there is little doubt that he’d soon be in the print shop.

The feds are in the print shop already. They’re printing up more dollars intentionally – to try to get inflation rates up… and to finance federal borrowing. It will be a miraculous thing if their new dollars don’t eventually cause inflation. But the macro-economists who run the print shop tell us not to worry. They’ve got it all under control. They’re already talking about when and how to withdraw the dollars they so helpfully provided during the crisis period.

The simpletons – who had no idea that the crisis would come… and then thought it could be easily contained… and then mistook it for a monetary, banking crisis… and then judged it over before it had really started…

…these same simpletons still do not understand that the problem is not a lack of money, it’s a surplus of debt…

…they now reassure us that they know just how much money to put into the system… and just when to take it out.

If you believe them… you might want to stay in stocks and US bonds. If not, you should head for cover.

The country is being run “by a gang of clueless bozos,” says Lee Iacocco, in his new book.

Source: Head for Cover

Probably most incredible is that the dollar has NOT collapsed. It has lost ground, and was trading at $1.43 per euro on Friday, but no one laughs at you when go to exchange dollars…or offer to pay in dollars rather than the local currency.

For the last 10 years, the money supply in the United States has expanded at roughly twice the rate of GDP growth. And the Fed doubled its balance sheet in just the last 18 months. This last bit of information is stunning. It took the central bank nearly 100 years to build a balance sheet of $1 trillion. Then, under the leadership of Ben Bernanke, it added another $1 trillion in just a few months.

What does that mean, exactly? It means they bought a lot of debt from US agencies and the financial sector. It means also that they “monetized” this debt…transforming it into cash by paying for it with money especially created for that purpose. It also means that the whole financial sector has a bigger financial base against which to lend. The Fed lends against its balance sheet to member banks. These banks then lend to other banks who lend to business and consumers. So the amount of potential credit – as well as the amount of actual cash – has gone up.

There is an iron law in economics. Quality and quantity vary inversely…which is another way of saying that when you add more of something…each unit is worth less than the unit that preceded it (assuming everything else remained unchanged.) Certainly, this is true of money. The more money in a financial system, the less each unit of it is worth. Add enough new money – as Zimbabwe proved recently – and each unit becomes worthless.

But so far, the dollar has not collapsed. It has fallen, but gently…

Meanwhile, the inflation rate has NOT gone up. Instead, it’s gone down. Go figure. You add that much monetary inflation and you’d expect to get a boost in the CPI. Nope. Not yet.

On the other hand, we’re already a year-and-a-half into a major recession/depression. You’d think you’d get deflation. That hasn’t happened either. Prices are down. But not as much as you’d expect, given the scale of the downturn.

Related to both the dollar and inflation is the bond market. Even more surprising is that the bond market has NOT fallen apart. Let’s see, a huge input of monetary inflation; that ought to kill the bond market. Then too, the biggest sales of Treasury bonds in history – needed to cover a $1.7 trillion deficit this year. That ought to kill the bond market too. And on top of it all is a projection from the White House telling us that the feds will add $9 trillion to US debt over the next 10 years. And that assumes a full recovery in the economy! Now, that ought to kill the bond market for sure.

Not at all! Bond yields have risen…but the 10-year T-note still only gives you 3.4%.

Of course, you say, it’s a depression. Bond yields always go down in a depression.

But if it’s a depression, how come commodities are up? And stocks are up? Above all, how come Chinese stocks are up? Everybody knows China earns its money selling products to Americans and other non-Chinese. If the rest of the world is in a depression, who is China going to sell to? How come China isn’t in a depression already? But there you are – there’s another thing that hasn’t happened. Chinese stocks haven’t collapsed.

And getting back to commodities, they’re all up. Commodity prices don’t go up in a depression; everybody knows that. They go down. But commodities are NOT in a bear market. Go figure.

And, of course, there’s gold. The metal gave up a dollar on Friday, but it’s still just $4 short of the $1,000 mark…and just a shadow below its all-time high. Gold is a commodity…but it’s also money in its purest, more reliable form. Commodities go down in a depression. Money goes up. But since gold is an alternative to paper money, it tends to go up only when paper money goes down. As explained above, the dollar has NOT collapsed. So why is gold going up? It should be going down, reflecting the effect of a recession…

There are two possible answers.

First, maybe the iron laws of economics have been repealed.

Or, second…maybe the iron laws just haven’t caught up to the market – yet.

Unemployment is at 9.7%. It will probably rise above 10% this month. The economy is supposed to be recovering. Now, The New York Times is talking about a “jobless recovery.”

You’ll remember the phrase. It came out in 2003. Then, the economy was allegedly recovering from a micro-recession. Economists were surprised that there were so few new jobs created.

What was really happening was that there was no genuine recovery. Consumers just decided to go deeper and deeper into debt – egged on by the feds. A regional governor of the Fed actually urged consumers to “go out and buy an SUV.” So Americans bought more products from the Chinese…on credit…and the Chinese enjoyed a boom.

And now the boom is over. Americans are paying down their debt. And unemployment is getting worse. This time the feds are pumping trillions into the system. This time, it’s not the consumer who is willing to go further into debt; it’s the government. And once again, few new jobs are being created.

Without jobs, the recovery is an impostor…a phony…a fraud. Without jobs, people have no extra spending power. So they can’t buy – except by going deeper into debt. They were willing to go further into debt in ’03-’07. But not this time. They’ve reached their limit on debt. Besides, with house prices falling, who would lend to them?

No new jobs = no new income. No new income = no new sales. No new sales = no new profits = no new jobs.

But what about the government? The feds are still willing to borrow. How come federal borrowing can’t create a new boom – even if it is a phony one – like the one in 2003-2007?

Federal borrowing, spending, bailouts and monetary inflation are not helping the real economy. But they are making a lot of money available for speculation. That’s why so many things are NOT happening. Investors are speculating on commodities, gold and Chinese stocks – for example. And US bonds.

But this is not a durable, reliable trend. And it’s not laying the foundation for a genuine recovery. Borrowing by the feds is different from borrowing by individuals. Private households can go broke. But they can’t take the dollar down with them. When the feds borrow, they pledge the full faith and credit of the United States – and its currency – as security. So, as they borrow more…the value of the US currency comes into doubt…then, into play…and then into jeopardy.

Investors eventually sell off dollars and US bonds…then, what should happen finally does.

Caution: what has to happen does eventually happen. But it doesn’t have to happen when you think it should. The big surprise might be how long it takes before these things happen. If we were Mr. Market, for example, we probably would not take gold much higher – not just yet. We’d let deflation take gold down for a while – long enough to separate the speculators from their money. Then, we’d let investors get used to falling prices – before bringing inflation back.

And, as promised on Friday, the answer to ‘What was the SEC doing?’

Harassing us!

Recall that last week, we reported the latest news on the SEC. Investigators wondered why the agency had let Madoff run billions in suspicious trades without ever checking them out. The SEC responded by saying it lacked sufficient resources. Then, New York Senator Schumer said he would propose a measure to increase the agency’s spending power by 75% – by allowing it to shake down the financial industry directly, rather than going to Congress for a budget allocation.

Which still leaves open the question of what the SEC was doing when it should have been making Madoff do the perp walk. We have the answer: the SEC was harassing us.

Yes, hard to believe that they would target your poor, innocent editor. And they didn’t, not directly anyway. Instead, they targeted one of our colleagues. This was a couple of years ago…when Bernie Madoff was at the top of his game.

We haven’t mentioned it in this space…on the advice of our lawyer. Judges don’t like it when you “try a case in public.” And the case still isn’t settled.

But we won’t discuss the merits of the case…only the circumstances around it.

This will help us understand what the SEC is really up to…and why the hope of regulating fraud out of existence is as vain and futile as trying to clear out a bar by using foul language.

Here’s what happened. One of our researchers discovered what he thought was a great investment opportunity. He called the target company and spoke to a VP in charge of public relations. What he heard convinced him that he was on to something, so he published a recommendation, sending a copy of it immediately to the company.

He got no response from the company. But a few months later, the SEC knocked on our door. What was their beef? That we had misled investors. How so? In our report, we told readers what the VP had told us. We carefully called it “insider” information…putting the word in quotes to let readers know it wasn’t the same as the forbidden ‘inside information.’ Anyone could have found out the same thing if he had just called the company, read the published reports, and put two and two together.

Our caution was lost on the SEC. They didn’t see the difference between “insider” information and inside information. What’s more, the fellow at the target company denied he had said what he had said. Curiously, he made no objection when the report was published; the objection came after the SEC started snooping around.

The SEC wanted blood. They thought they could get an easy win against a little guy in Baltimore. They wanted us to turn on our own associate…to stop defending him and cop a plea. Obviously, we couldn’t do that. We stood behind our man.

Then came a quirky turn of events. Both the researcher and your editor’s company were charged with what was effectively a new crime – a federal case, no less. The SEC, remember, is supposed to be protecting investors from stock fraud, manipulation, and ‘insider trading.’ But there was never any allegation of manipulating a stock or insider trading. Instead, the agency charged us with NOT having inside information. We never traded in the stock at all…or manipulated it in any way. So the feds alleged that we did not have any inside information to trade on…and that therefore our representation – of having “insider” information (in quotes!) – was a kind of fraud.

And the whole case turned on a telephone conversation between a stock market analyst and a public relations guy in a company. One said one thing; the other said another thing. Reporters make mistakes all the time; so do their sources. But this was the first time the government made a federal case out of it.

We believe our analyst. The SEC believed the other guy and spent millions trying to prove that our fellow lied. No one who bought the research report on the stock complained, let alone threatened a lawsuit. Prior to any SEC probe, refunds were issued to anyone who asked (most did not). Yet the SEC, protector of the public interest, spent years…and millions…on the case – while Bernie Madoff was stealing billions from his clients.

Case against your editor’s company: judges ruled that we were innocent.

Case against our colleague: still undecided at the appeals court.

Case against SEC: guilty of negligence, dereliction and humbug.

Until tomorrow,

Bill Bonner

Source: This Recovery is an Imposter

Even Alan Greenspan admitted he had “found a flaw” in his own thinking. We will have to imagine the giggles from the back of the room – if anyone had been awake. It was as if Stalin had confessed to being rude to his mother or Bernie Madoff copped a plea for shoplifting. The mea was fine, but the culpa didn’t seem to measure up to the facts. He, more than any living human being, was responsible for the biggest financial debacle in history; you’d hope he’d be a gentleman about it and hang himself.

Meanwhile, the queen of England visited the London School of Economics and had a question: how come economists were not on top of this thing?

Last month, they replied. In a three page letter they avoided the simple truth – that their trade was no more reliable than fortune telling and marriage counseling. The letter claimed that a “psychology of denial” prevented government and financial eyes from seeing the catastrophe in front of them. It was “a failure of the collective imagination of many bright people”, they said.

In fact, it was the exact opposite — imagination run wild. Economists imagined a world without yesterday or tomorrow… a world in which you could run up debts forever and never have to pay them back.

Last week, Timothy Geithner promised the Chinese that the US economy would recover thanks to demand from the private sector. That was his way of reassuring America’s biggest creditor that the public sector wouldn’t continue to run huge deficits – practically an outright lie. But it’s one thing to stiff the Chinese; it’s another to stiff time.

Adjusted for inflation, the US consumer’s earnings barely rose from the ‘70s. By some measures, he had actually less disposable spending power in 2007 than he had in 1973. And now his income is going down. The June number reflected the biggest drop in income in 4 years. Salaries and wages fell 0.4% in June… the 9 th drop in the last 10 months. How is it possible for him to spend more?

We pose the familiar question only to set up an unfamiliar answer. In the past, the consumer reached into the future. In many cases, he reached beyond the future… into never, never land. Consumers spent money they hadn’t earned yet… thus bringing forward purchases that should have been made years later. The accumulated effect of this was to add $35 trillion in extra spending to the world economy – from America alone – over the course of the great credit expansion, 1945-2007. That’s why we have a depression now; because consumers already spent what they would normally be spending now.

Time always gets even. Now, it is the past that is doing the reaching. The automobile bought in 2006… the house bought in 2005… the vacation taken in 1999 – the ghosts of yesteryear spending reach for Americans’ paychecks. Of course, in some cases, consumers spent more than they could reasonably expect to pay back – ever. They reached so far the poor ghosts are disappointed. Lenders realized that they’d never get their money back, which is what led to the credit crunch and the collapse of Wall Street.

Of the big five – Bear, Lehman, Goldman (NYSE:GS), JPMorgan (NYSE:JPM) and Merrill (NYSE:SQD) – only two survived intact. And we know now that Goldman only survived because Henry Paulson, former CEO of Goldman, then Treasury Secretary, arranged a hidden bailout. He had the government step in to save AIG, which owed Goldman $13 billion.

From one scam to another… from bailing out Wall Street to bailing out the entire world economy, the more stimulus programs fail to bring a recovery, the more economists call for more stimulus.

What are they thinking? Since neither the private sector nor the public sector has any savings from the past, additional demand from either sector must be borrowed from the future. (Setting aside ‘quantitative easing’… or Zimbabwe – style stimulus… an even bigger fraud.)

The purest illustration of how this works is in the popular ‘cash for clunkers’ programs. Instead, of letting the consumer buy a new car when he is ready, the feds give them money to buy now. So, he buys in 2009 and not in 2010. What good is accomplished? It is as if they didn’t expect 2010 to ever arrive… as if they thought they could stop the sun and the seasons… and the Chinese… forever. Like moths in amber, their wings will never tatter… nor will their faith flag. The dollar will always be strong. US bonds will always be in demand. And the future will never arrive.

But the more economists try to stitch up the future; the more it gets away from them. After the 2010 sales have been moved forward to 2009, they will have to reach into 2011… and then 2012… all the way to the end of time.

Source: Stitch in Time

But it’s clear the arrests by Italian authorities of two “Japanese-looking” men allegedly attempting to smuggle $134.5 billion worth of US bearer bonds across the Swiss border is the biggest financial crime in history. And one with major implications for America’s economic security.

For those of you who don’t know, a report surfaced on Monday, June 8, on an obscure Vatican-sponsored news website, AsiaNews.it, that Italy’s financial police (Guardia Italiana di Finanza) had “seized US bonds worth US 134.5 billion from two Japanese nationals at Chiasso (40 km from Milan) on the border between Italy and Switzerland.”

According to the report, these securities included “249 US Federal Reserve bonds worth $500 million each, plus ten Kennedy bonds and other US government securities worth a billion dollar [sic] each.”

If the report is true (it has been relayed by the Associated Press, Bloomberg, The Times and the Dow Jones news service), it means these two as-yet-to-be-identified men were carrying securities amounting to the GDP of New Zealand – or enough money to fund three Beijing Olympics – in non-negotiable bonds in their suitcase.

As Bloomberg put it, “If economies were for sale, the men could buy Slovakia and Croatia and have plenty left over for Mongolia or Cambodia.”

The story is filled with bizarre and incongruous details. Enough, in fact, to make the mind of even the most determined news hound spin.

1. First, there’s the obvious question of whether these billion and half-billion dollar notes are real or fake. According to the AsiaNews report, “Italian authorities have not yet determined whether they are real or fake but […] if they are fake, the matter would be even more mind-boggling because the quality of the counterfeit work is such that the fake bonds are undistinguishable from the real ones.”
2. The story has received a lot of coverage in Europe and Asia. But US media outlets have ignored it, despite the fact that it concerns either the biggest ever counterfeiting or the biggest ever smuggling of US bonds. (A third possibility is that the story itself is a fake. Even so, this would merit serious attention as it implies that someone or some state or state agency is interested in destabilizing the value of US debt at a time when it’s most sensitive to destabilization, i.e., when America is issuing most of it.)
3. The story broke smack in the middle of heightened concerns over the stability of US bonds markets.  Treasury Secretary Tim Geithner has just completed a trip to China, where he did his best to assuage Chinese fears that US fiscal and monetary policy is undermining the value of US government and agency debt. And the BRIC nations – Brazil, Russia, India and China – have recently stirred the pot by calling for a less dollar-centric global currency system.And following the report of the bond arrests, Japan – the second largest foreign holder of US debt after China – felt it necessary to come out with the following statement via its finance minister: “We have complete trust in the fact that the U.S. views its strong-dollar policy as fundamental. So our trust in U.S. Treasuries is absolutely unshakable.” (As Karl Denninger points out on his blog, The Market Ticker, the Japanese said in December 1941 that all was well, too.)

1. According the Dow Jones Business News, “An official at Japan’s Consulate General in Milan said Tuesday that Italy was still investigating the case, adding it wasn’t confirmed that the two men are Japanese.”So are the alleged smugglers/counterfeiters Japanese or aren’t they? And if they aren’t, why did the press reports say they were?According to Dow Jones, the Japanese have “sent a letter asking for further information to the Italian tax police as well as prosecutors.” But why the delay?

1. A breaking report from Joe Weisenthal at The Business Insider, snatched from Japanese TV, says the “Japanese” bond smugglers are now missing. If this was a simple case of counterfeiting (albeit the biggest in history), it’s highly unlikely the Italian and US authorities would have let the men carrying the bonds simply slip off into the night…
2. The amount seized should ring alarm bells. On March 30 2009, the Treasury Department announced that $134.5 billion remained in the TARP. The stated amount of seized bearer bonds was $134.5 billion.
3. According to JS Kim of investment research company SmartKnowledgeU, “The two well-dressed Japanese men opted to travel to Chiasso on a local train normally full of Italian manual laborers commuting to Switzerland. If they were really intent on successfully smuggling these bonds, counterfeit or real, why would they not take more care to select a travel route in which it was literally impossible for them not to stick out like two sore thumbs?
4. The bearer bonds were discovered in a hidden briefcase compartment after a customs inspection. As Kim also points out, “If the bonds were indeed authentic and owned by a nation state, they could have been transported in a diplomatic pouch exempt from customs searches that would have guaranteed transport without detection.”

Here at Notes we have two theories about the bond arrests, presuming the story is legit. (That is to say presuming the reporting on the story is legit. More on this later.) Both have serious implications for the US economy and all who depend on it for their livelihoods.

The first possibility, as we see it, is that the events in Italy are evidence of sophisticated economic espionage and an attempt by a (hostile) foreign power to undermine US economic power.

In other words, somebody wants to destabilize the US bond markets by spreading the word that US bonds can be forged, but that “the quality of the counterfeit work is such that the fake bonds are undistinguishable from the real ones ” (as the original report put it). Raising legitimate concerns about the ability to withstand counterfeiting efforts is a sure-fire way of sabotaging a currency.

It wouldn’t be the first time that such a strategy has been used to destabilize an enemy power. During World War II, Hitler launched Operation Bernhard to crash the British war economy. By the end of the war, it had produced 132 million expertly counterfeited British pounds – a sum that represented about 15% of all British pounds in circulation at the time. The British ran a similar counterfeiting operation against the Nazis.

It seems careless, to say the least, to get caught with $134.5 billion dollars worth of securities by a regular inspection on a train. We’ve already ruled out that this wasn’t an official state operation (otherwise the bonds would have traveled in a diplomatic pouch). So it’s certainly odd that people sophisticated enough counterfeit or steal $134.5 billion worth of US government bonds couldn’t think of a safer way to transport them.

The implication is the “Japanese” interlopers wanted to be caught. And they wanted the world to know that US bonds could be so expertly forged.

Who would want to destabilize US economic power? Who would have the technology and the know-how to print such convincing forgeries? Who is a declared enemy of the US? Who might have “Japanese” looking agents working for them? North Korea would have to top the list of suspects…

Also, there’s the question of why the Italian authorities didn’t allow the “Japanese” couriers to deliver their illicit cargo to its destination (and therefore also apprehend the intended recipient/s of the bonds). Surely, that would have been of interest to the Italian authorities, who seem to have been acting on a tip-off. (Unless you believe that the Italians are in the habit of searching false-bottomed suitcases of well-dressed Asians on their way to Switzerland.)

One explanation for this is that the Italians believe these bonds are real. Italian law prevents people importing or exporting more than €10,000 in cash. And the penalty for violating the law is 40% of the money seized. That would mean the jackpot of the Italian government – the fine for this particular haul would be €38 billion. This would go a long way to eliminate the country’s public debt.

This brings us to our second theory. If the bonds turn out be real, it points to the possibility that the US Treasury may have been secretly issuing bonds to foreign nations to finance America’s deficits. This has worse implications than the sabotage theory. Let us explain…

The bonds the Italian authorities seized earlier this month were bearer bonds. That means they are unregistered – whoever holds the physical piece of paper owns the instrument.

This is where the plot really thickens. Since the passing of the US Tax and Fiscal Responsibility Act in 1982, the US doesn’t officially issue this kind of bond anymore. And according to the Treasury’s own figures, the approximate amount of debt outstanding in bearer bonds as of May 2009 is just over $100 billion – roughly $34 billion less than the amount wound up in a false-bottomed suitcase on a train from Milan to Switzerland.

It seems the only way the bonds could be real is if the Treasury has been issuing bonds it doesn’t want anyone to know about.

According to underground investor Karl Denninger at The Market Ticker, this is “one of the few explanations that actually fits the facts.” And Denninger goes a step further. He writes:

If in fact previous administrations were issuing “off-book” Treasury debt in this fashion to sovereigns then implications are truly explosive as such issues are blatant and outrageous unlawful acts and would expose everyone involved to severe criminal penalties.

This wouldn’t surprise us in the least. Right now the US government is on a $12.8 trillion spending spree. As we’ve said before, it’s now the biggest player in the US economy. And it’s destined to be this way for a long time to come.

Put simply, the government money, and a handful of chosen stock shoot up. (To find out which stocks are benefiting from this unprecedented spending splurge, read on here. )

This story has more holes than a Swiss cheese. We know from experience here at Notes (your co-editor spent two years working as an investigative reporter in his native Ireland) that there is rarely smoke without fire when it comes to news stories. But one aspect of this story still puzzles us… and it’s a part of the story nobody to date has questioned: What was an obscure Vatican-sponsored news outfit doing breaking the largest financial crime story all time?

As far as we can tell, AsiaNews.it broke the story on June 8. Major news services followed on with their own reports much later. Bloomberg, for instance, only got to it yesterday. So how did AsiaNews.it, a website linked to the Ponticial Institute for Foreign Missions and funded by the Vatican scoop the major news agencies on the bond story?

AsiaNews.it’s About Us page freely admits that it is an anti-Communist organ of the Roman Catholic Church, “nobly dedicated to China and her people.” The organization’s missionary zeal is not difficult to detect:

Since [Chinese] university students have internet access, we think that AsiaNews will help them to be familiar with the impact Christianity has on Asian and Chinese society. Already many Chinese intellectuals think China can be saved by Christianity, so as not to explode into a soulless market or a dictatorship that humiliates the individual.

Whatever the truth behind the bearer bond arrests , we know it doesn’t bode well for America’s economic future. At best, it demonstrates that the US faces economic sabotage from an (as yet) unknown source. At worst, it’s evidence of underhand behaviour by US authorities to finance the country’s spiraling debt problem.

Even if the case can be put down to (a highly incompetent) nation trying to offload its dollar holdings, it underscores our argument here at Notes that investors need to closely watch US debt markets to determine the future of their investments.

This year, it’s estimated that the US Treasury Department must raise $15 billion a day in debt just to keep the country afloat and Team Obama in pocket. It’s our view that this is America’s Achilles’ heel.

The US economy has already been brought to its knees by too much private debt. We believe its public debt problem could one day deal the country a deathblow.

Yesterday was beautiful in London. We wandered along the banks of the Thames and crossed Waterloo Bridge over to Covent Garden. Everywhere, people were sitting out on the grass… standing outside pubs… walking hand in hand. Everyone had the same idea – to take advantage of the nice weather before it goes away.

Last year, London had a beautiful summer too. But we were gone that week and missed it.

Alas, many of the best things in life are fleeting. And thankfully, so are the worst things.

What put us in such a reflective mood were yesterday’s news reports. The Dow rose again – up 19 points this time. Gold edged closer to the $1,000 mark – at $984. Oil traded at $68. And the dollar fell to only $1.43 against the euro.

These trends – not to mention the broad rise in commodities and stocks worldwide – lead many investors to think that the fair weather is back, permanently. Asset prices are rising. Investors are less afraid of risk. Hallelujah – a dove with a sprig of green in its beak!

Of course, it may be true. But our advice, dear reader, is to take an umbrella with you anyway. As far as we can tell, nothing has happened to disturb the major weather pattern that began developing two years ago. Anyone could see it coming years in advance. ‘You gotta expect trouble when the average house is more expensive than the average person can afford,’ we kept saying.

But it was only when high winds hit the housing market that the newspapers took notice. Then, for 40 days and 40 nights the rain came down.

First, the house flippers were caught off guard. They were in the middle of flipping condos when all of a sudden the wind shifted and sent their contracts aloft. Mortgage rates were rising and buyers disappeared. The flippers lost their deposits and walked away from empty buildings.

Then, resets and higher rates blew the roof off the sub-prime market.

Then, the whole housing sector was getting knocked down – builders, suppliers, and financers.

Next came the credit crunch… when major lenders and investment banks realized that they were in heavy seas. Their ships were swamped with mortgage-backed debt and derivatives… and their captains were morons. Lehman went down. Wall Street abandoned ship. And the feds sent out rescue planes.

By late in 2008, everyone was taking shelter. Businesses were cutting payrolls. Banks were squeezing their reserves. Consumers were staying at home. And GM was hiring bankruptcy lawyers.

Everything was falling in price – houses, office buildings, stocks, commodities… practically everything except the US dollar, US bonds, and gold. These three were seen as the only safe refuges for storm-tossed investors.

But on March 9, 2009, came a lull. Reluctantly, investors came out of their storm shelters. The skies lightened…the sun shined. Oil has gone up 53% since then. Stocks worldwide are up about 30%.

And now…people say “the worst is behind us.”

We meteorologists here at the Daily Reckoning watch the skies like everyone else. But we also read reports from big storms of the past. And what we notice is that this doesn’t look like the passing storms of the ‘80s or ‘90s. It looks to us like a major change in weather patterns. To be more precise, it looks to us like the Great Storm of the ‘30s. Do you remember that one, dear reader? No? Well, we don’t either, but we’ve read the histories. It was a doozy. And it began… well… just like this one.

In 1930, six months after the initial storm front passed world output was down about 15%. Today, it is down about 15% too. Stock markets were only down about 20% in mid-1930. Today, they’re down about 35%. And world trade slipped about 15% in the six months following the onset of the Great Crash of ’29. Today, it is down 25%.

One thing you notice is that like the Great Depression, this downturn is global. A collapse in world trade followed the Crash of ’29. It is usually blamed on two protectionist bumblers in Congress – Smoot and Hawley. But in a real depression trade falls anyway. World commerce needs to readjust to new realities… whatever they are. That’s happening again now.

The other thing you notice is that this adjustment takes time… and takes the losses much further… much deeper… than anyone expects. The actual bottom in the ‘30s didn’t come until 2 to 3 years after the crash. And it took stocks down all over the planet to about 65% below their peaks. World output eventually fell to only about 2/3rds of what it had been in the late ‘20s.

It took two decades and a major world war before the world was back on its feet.

More news from Manraaj Singh on emerging markets….

“Over the last four weeks $12 billion in new money has flowed into the emerging markets. That has triggered the biggest rally in the benchmark MSCI Emerging Markets Index since it was set-up in 1987. It’s up by 61% since February. That brings us right back to where markets were before they tanked.

“No one in their right mind honestly believes that the global economy is going to return to the pace of growth that we saw before the crash anytime soon. Not even Alastair Darling. But it’s all a matter of timing. I believe that the emerging markets offer the best value over the long-term. That’s why I am now looking at India and China for our next investment plays. But investors who pile-in right now risk getting badly burnt.

“You see, analysts are viewing the short-term outlook for the emerging markets right now through rose-tinted specs. They have hugely over-estimated how much emerging markets companies will earn this year. Figures for the first three months of this year show that analysts’ estimates were 41% above what the companies actually earned.

“There may still be one more surge in the emerging markets before the correction. We seem to be reaching the point when every money manager without a clear idea of what’s going on jumps on the bandwagon. You can bet that many of them are going to be in tears before the leaves turn gold.

“An extreme fund flow like this is a contradictory indicator. It points to a coming market drop rather than a sustainable rise. The crash in emerging stock markets is on its way. I’ll let you know when it is time to get in.”

Publisher’s note: Manraaj Singh 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…

*** “Treasuries Tumble,” announced a cover of Barron’s recently. Oh my. Long bonds are down 20% since January.

Pity the poor Chinese. They’ve got $768 billion worth of them.

And pity poor Tim Geithner. He’s over there right now on a fool’s errand, lying to the Chinese:

“Geithner Tells Chinese its Holdings Are Safe,” says the Washington Post.

Reuters went on to report:

“His answer drew loud laughter from his student audience, reflecting skepticism in China about the wisdom of a developing country accumulating a vast stockpile of foreign reserves instead of spending the money to raise living standards at home.”

More about this later in the week… *** “Those people did not become French in the last five months,” says Mitch Daniels, Republican governor of Indiana.

He was referring to the people who re-elected him. His point was that Americans are not necessarily in favour of socialism. They may be fed up with what they see as the failures of capitalism. But they’re not ready to vote for Nicholas Sarkozy.

But the country has clearly moved towards more government intervention in the economy. In 1986, 40% of Americans thought government regulated the economy too much. Now, 40% think it doesn’t regulate enough. And get this. The Economist reports the results of a worldwide poll. Asked “are people better off under free markets,” 75% of Indians say ‘yes’ and so did about 72% of Chinese. But put the question to Americans and only about 69% think so.

Even Italians are more in favour of free enterprise than Americans. Go figure.

The Economist passes along the thoughts of an American lawyer to explain it: “The disaster in the housing and mortgage markets shows that free markets don’t always get incentives right or generate the information people need to make wise decisions. There may be times, he adds, when government is better suited to giving people the information they need.”

Ha. Ha.

Information? What information was it that people didn’t have? All the information was not only available – it was free. We reported it here at the Daily Reckoning – for free. Day after day… we read the headlines and passed along the statistics. What was hidden from view? What was unknown?

This information was available to the government too. Its thousands of regulators, representatives, researchers, and consumer advocates had computer terminals and newspaper subscriptions. They even had thousands of Ph.Ds in economics whose JOB IS TO STUDY THE ECONOMY!

If government were really able to give “people the information they need,” you’d think that one of these earnest meddlers would have whispered to Secretary of the Treasury… or maybe to the head of the Fed: ‘Hey… better tell the voters to watch out… this thing is getting out of control.’

But do you remember a word from the Secretary of the Treasury… from the Fed… from the SEC… from the other busybody parasites who live on the public payroll? We don’t. All we remember is how they told us to “buy an SUV” and how derivatives “spread the risk to those who are able to bear it” and how “sub-prime mortgages help increase home ownership.”

The government does a better job of running the economy? Ha. Ha.

Source: A Storm on the Horizon

U.S. stocks were mostly higher in thin trade on Friday, as investors eyed retail sales on the first day of the shopping season after the Thanksgiving Day holiday, to gauge the extent of weakening consumer demand.

European and Asian shares were also higher, despite the attacks in Mumbai, India, while U.S. Treasury debt prices and the U.S. dollar both gained as investors continued to look for safe-havens as global economic growth slows.

“It’s a light volume day so you’re going to see some choppy trading, with so many people out,” said Robert Finkel, consumer trader at Stifel Nicolaus in Baltimore of the U.S. stock market.

“I’m watching how things go from a retail standpoint today – we’ve heard a lot of speculation about how bad it’s going to be, now we’ll get some proper feedback.”

The U.S. holiday weekend will test the strength of consumer sentiment, a main driver of the U.S. economy, as the country faces its worst financial crisis since the Great Depression. If the U.S. consumer fails to buy, companies across the globe can expect to see fewer exports and profits.

The Dow Jones industrial average rose 32.42 points, or 0.4 percent, to 8,759.03. The Standard & Poor’s 500 Index rose 0.66 points, or 0.1 percent, at 888.34. The Nasdaq Composite Index shed 11.99 points, or 0.8 percent, to 1,520.11.

The S&P’s retail index dipped 2.3 percent.

The U.S. stock market was closed Thursday for the Thanksgiving holiday and is trading for half the day on Friday. On Wednesday, stocks ended higher, capping the Dow’s biggest four-day percentage gain since 1932.

Technology shares slid after signs of a downturn in global chip demand as STMicroelectronics cut its fourth-quarter outlook. Industry sources said Taiwan companies want to slash costs. The semiconductor index shed 1.1 percent.

OPEC MEETS

U.S. light crude for January delivery stood at $51.52 a barrel, down $2.90, on course to end the month down more than 20 percent, as OPEC ministers prepared to meet in Cairo to discuss potential further supply cuts to combat a global fall in demand .

In the U.S. Chevron fell 1.9 percent tracking oil lower.

Indian stocks ended higher despite the attacks in Mumbai, but India’s 10-year bond yield fell to its lowest level in three years on expectations that the attacks will an impetus to central bank interest rate cuts.

Globally, the MSCI all-country world index was 0.1 percent firmer, although it has gained more than 10 percent this week, the first weekly gain in four weeks.

“On a range of measures, there is undoubted value to be found in many of the world’s equity markets,” said Sarah Arkle, chief investment officer with Threadneedle Asset Management.

The pan-European FTSEurofirst 300 was up 0.7 percent, as buoyant pharmaceutical shares eclipsed a drop in cyclical mining and industrial sectors.

Earlier, Japan’s Nikkei average climbed 1.7 percent to close out its best week in a month.

The U.S. dollar regained traction against major currencies after early losses. The euro lost 1.8 percent to $1.2656 . The dollar was flat at 95.36 yen .

Benchmark 10-year Treasury notes traded higher in price for a yield of 2.9673 percent. The benchmark yield, which moves inversely to prices, fell to as low as 2.82 percent on Friday, according to Reuters data, marking the lowest in at least five decades.

Overall, benchmark yields are on track for the biggest monthly fall in at least 12 years, according to Reuters data, as investors have stampeded into lower-risk investments on signs of ever-deepening economic distress. The 10-year yield has shed more than a full percentage point since the end of October.

Euro zone government bonds rose, reflecting concern about the economy and expectations of interest rate cuts. Two-year Schatz yields were last down 3 basis points to 2.202 percent.

By Nick Olivari
NEW YORK, Nov 28 (Reuters)

And if the The Institute for International Finance Inc.’s new proposal on “mark-to-market” accounting is implemented, Wall Street will have achieved this objective.

Needless to say, that would be bad news for shareholders.

Once upon a time, asset valuation was easy, even for banks. Whatever you paid for it was the value at which you carried it in the books. In the years of inflation, shysters would wander round the country looking for companies that carried their Head Office at its value when built in 1926.

The only exception was in the few cases such as dud bank loans. If the asset was clearly worth far less than you paid for it, then you would write it down to a new lower value. More often than not, you wrote it off altogether and forgot about it. However, if you wanted credit for an asset’s increase in value, you had to sell it – simple as that.

The only exception to this methodology arose in a few trading operations, such as the investment banks – at the time, much smaller – and commodities traders, where positions were written up or down, or in other words, “marked-to-market” at the end of each day, according to that day’s closing prices. By and large, the only assets marked to market in this way were actively traded shares and bonds.

The advantage of this system for shareholders is that it was difficult for management to play games. There was no possibility of management declaring a higher value for an asset while the company still owned it and paying itself a bonus based on the increase. That’s a big protection, because unless the asset is very liquid or actively traded, it is impossible to be really sure of its value until it is sold.

Banks began to move to mark-to-market accounting in the 1980s. They quickly discovered that it could prove a bonanza for management if there was any kind of profit sharing bonus arrangement, even more so if stock options were involved. In a bull market, it was no longer necessary to sell a building or an equity position to record a profit on it; you could record profits and pay yourselves bonuses as you went along. The technique became particularly profitable when there wasn’t a true market for an asset; in that case management was free to make up a value, using some internal mathematical model.

Naturally, if a bear market occurred, mark-to-market accounting resulted in much larger losses than traditional accounting. First, the value of assets had been marked up to the absolute maximum bull market peak, so they had to be written down that much further than they would have under historic cost accounting. Second, under historic cost accounting an asset whose value was temporarily diminished but was still fundamentally sound did not have to be marked down. Thus share positions, or bonds whose credit rating had become impaired, could still be held at book value.

However, under mark-to-market accounting, those positions had to be marked down to their new value and a loss taken. In theory, mark-to-market accounting was more precise in a bear market. In practice, it allowed management to pay themselves bonuses for year after year, and then declare one utter disaster year, in which everything would be written off and most of the profits of the preceding decade would disappear in smoke (without, however, management having to repay the bonuses from the boon years).

Of course in some cases, most notoriously Enron Corp. (OTC: ECSPQ), it was taken too far and the company went bust, but hey, that’s capitalism.

The new FAS157 that came into effect last December did not change much in principle, but codified some of the nastiness. Under it, assets were now classified into three “levels” according to how much of a market there was. “Level 1″ assets had a liquid market – no problem. “Level 2″ assets could be valued by reference to a liquid market in a related asset. “Level 3″ assets had no easily relatable market, and therefore had to be valued by internal mathematical models.

Unfortunately for Wall Street, the new system, which had appeared to offer opportunities for endless bonus-creating mark-ups, was put in place right in the middle of the subprime mortgage crisis. All the collateralized debt obligations with subprime mortgages underlying them became a problem, because the very thin asset-backed securities index or “ABX” market for them collapsed, with AAA-rated bonds being quoted at less than 50 cents on the dollar. That paper, which had all been recorded in Wall Street’s books as “Level 2″ had to be quickly shifted to “Level 3″ – otherwise huge losses would have been taken (huge losses WERE taken; but these would have been even larger).

Fortunately for Wall Street, astute lobbying had ensured there was a loophole in FAS157 – if the market for an asset was a “distress” market without willing buyers or sellers, the asset no longer needed to be counted as Level 2 but could be shifted to Level 3. Naturally the ABX market was a “distress” market – nobody wanted to sell at those prices, and it was highly distressing to management how far prices had fallen. So the subprime mortgage-backed paper was duly shifted to Level 3, increasing those assets by over $30 billion in one quarter at Goldman Sachs Group Inc. (GS), for example, giving Goldman $96 billion in Level 3 assets, nearly 3 times its capital.

Nevertheless, the idea that prices might have to be marked down sharply in a bear market was unpleasant. What’s more, bear markets could last for years, in which write-down after write-down could occur, wiping out profits year after year and preventing bonuses from being paid. Wall Street lifestyles were seriously threatened!

Now the Institute of International Finance, Wall Street’s tame think-tank, has come up with a solution. Prices should still be marked UP to market, but in difficult times they should no longer have to be marked DOWN to market. In the long run, this would turn Wall Street balance sheets into gigantic collections of waste paper. In the short run, it would preserve profitability and bonuses. And if it all goes wrong in the end, well, as The Bear Stearns Cos. Inc. (BSC) rescue showed, what are taxpayers for?