There is a risk in holding cash in an environment of asset price inflation – a condition that usually occurs when governments create large fiscal deficits and inflate the money supply. The practice is endemic to banana republics and declining empires…and it is happening in the US at this very moment.

The global recession and financial crisis have refocused attention on government stimulus packages. These packages typically emphasize spending, predicated on the view that the expenditure ‘multipliers’ are greater than one – so that gross domestic product expands by more than government spending itself. Stimulus packages typically also feature tax reductions, designed partly to boost consumer demand (by raising disposable income) and partly to stimulate work effort, production and investment (by lowering rates).

The existing empirical evidence on the response of real gross domestic product to added government spending and tax changes is thin… But the evidence is quite strong that these policy responses usually trigger inflation.

I suppose that even someone without any common sense might understand that a “strong currency” over longer periods of time reflects a high degree of prosperity and economic success, whereas a chronically weak currency is symptomatic of economic imbalances, such as a lack of competitiveness or overconsumption, arising usually from excessive supply of money and credit.

I would also suppose that even if someone never travels overseas, he would understand that if the US dollar loses 50% of its value against all the other world currencies (everything else being equal), it means the US is 50% poorer relative to the rest of the world. (Now, this is not entirely correct, since the US has overseas assets that would appreciate in value in USD terms).

Moreover, stock price movements become extremely volatile and erratic in countries with a depreciating currency. In the long run, the depreciation of the currency will usually more than eliminate the gains in local currency terms. So, whereas in 2007 both the Dow Jones and the S&P 500 exceeded their previous highs reached in 2000 in US dollar terms, these indices failed to make new highs in Euro terms. In addition, whereas the US economy expanded in US dollar terms between 2001 and 2007, in Euro terms it actually contracted!

Even with the S&P 500 having shot up since the beginning of the year by over 25%, it has merely kept pace with the price of gold. And during the last 10 years, the S&P has lagged behind the official US inflation rate…while lagging VERY far behind both the euro and gold. Sine the end of 1999, the S&P 500 has delivered a total return after inflation of about MINUS 25%.

Unfortunately, the US is not the only country that is busily debasing its currency. “Everyone” is doing it. Because of the current collective debasement of all paper currencies by central bankers, I believe that precious metals and mining companies will maintain their purchasing power.

In the 1980s the US dollar was a very strong paper currency compared to the Mexican Peso. Today, there is no paper currency that is as strong relative to the US dollar as the US dollar was relative to the Peso in the 1980s! The only “currencies” that have a chance of becoming as strong against the US dollar as the US dollar was against the Peso between 1979 and 1988 are precious metals such as gold, silver, platinum, and palladium.

Also, I should add that precious metals could appreciate even if the US dollar miraculously recovered strongly against foreign currencies for an extended period of time. Such dollar strength would probably be a symptom of some horrible economic or political problems around the world, which could be friendly to precious metals.

Central bankers and pundits seem to believe that they have averted the second Great Depression, while ignoring the fact that more and more debt produces less and less GDP and fewer and fewer jobs.

For now, though, the low ten-year bond yield is the lifeline from which all support flows. Much of the investment universe holds together because money can still be had for cheap – not by the volition of a cooperative private sector, rather induced by a US government that simply distributes money for free. Such an ill-conceived idea could only have been born in the test tube of a central banker.

Private lenders comprehend the difficulty of making profits when being forced to lend for nothing, so the government increasingly finds itself to be the interest-free lender of last resort.

Ultimately, if central bankers continue this process for long enough, it is the dollar, and any currency or economy still pegged to it, that could eventually crash. Therefore, we investors find ourselves in the precarious position of having to maintain sufficient liquidity, but not too much in case the real value of these liquid reserves is wiped out by politicians and central bankers gone mad.

Regards,

Dr. Marc Faber,
for The Daily Reckoning

When Currencies Crash originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."

Keynes noted in the General Theory that, according to Gesell’s proposal, “currency notes (though it would clearly need to apply as well to some forms of at least bank-money) would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps could, of course, be fixed at any appropriate figure. According to my theory it should be roughly equal to the excess of the money-rate of interest (apart from the stamps) over the marginal efficiency of capital corresponding to a rate of new investment compatible with full employment.” And although Keynes found “the idea behind stamped money sound”, he nevertheless conceded that there would be difficulties in the implementation of this scheme:

But there are many difficulties which Gesell did not face. In particular, he was unaware that money was not unique in having a liquidity-premium attached to it but differed only in degree from many other articles, deriving its importance from having a greater liquidity-premium than any other article. Thus if currency notes were to be deprived of their liquidity-premium by the stamping system, a long series of substitutes would step into their shoes – bank-money, debts at call, foreign money, jewelry and the precious metals generally, and so forth…there have been times when it was the craving for the ownership of land, independently of its yield, which served to keep up the rate of interest; though under Gesell’s system this possibility would have been eliminated by land nationalisation. (John Maynard Keyes, General Theory, London, 1936, Chapter 23)

I briefly discussed Gesell’s ideas because his books would make excellent bedtime reading for Comrade Obama. I doubt, however, that the Commissar can indulge in much reading time since he has embarked on micro-managing the economy. Also, as Keynes himself admitted, there are enormous problems associated with the “stamping system”, as well as with the “hat system” explained above by Mankiw, because savers would turn to other forms of “money” such as precious metals, non-ferrous metals, diamonds, paintings, stamps, cigarettes (see also below), metal coins, ecstasy pills, cocaine, prepaid cards, etc. But back to Mankiw!

Mankiw: If all of this seems too outlandish, there is a more prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead, the Fed commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates – interest rates measured in purchasing power – could become negative. If people were confident that they could repay their zero-interest loans in devalued dollars, they would have significant incentive to borrow and spend…

Yes, real interest rates could be strongly negative, as was the case in the 1970s, which generated high inflation and high nominal GDP growth rates but a collapse in bond prices (see Figures 1 and 2). Currently, Mr. Mugabe maintains in Zimbabwe by far the lowest interest rates in the world in real terms. But who is lending him money? What about capital spending and consumption in Zimbabwe? Go and look for yourself, Professor Mankiw! But there is no need to travel that far. After all, it is far too uncomfortable for an academic at Harvard. Closer to home – in the US – there is sufficient evidence that consumption as a percentage of the economy fell in the inflationary environment of the late 1960s and 1970s when interest rates in real terms were mostly negative.

Mankiw: Ben S. Bernanke, Fed chairman, is the perfect person to make this commitment to higher inflation. [MF: I am in full agreement on this point.] Mr. Bernanke has long been an advocate of inflation targeting. In the past, advocates of inflation targeting have stressed the need to keep inflation from getting out of hand. But in the current environment, the goal could be to produce enough inflation to ensure that the real interest rate is sufficiently negative…

I have a far simpler solution for creating inflation (for which I should obtain a Nobel prize in economics) than the half-baked measures proposed by Gesell, Mankiw, and his students, in order to create “more demand for goods and services, which leads to greater employment for workers to meet that demand”. The government could issue to each US man, woman, and child free vouchers for different goods and services, which would have a three or six months’ expiry date.

There are 310 million Americans. The government could issue 310 million vouchers to be exchanged for a new car, 100 million vouchers to be exchanged for a $500,000 home, a billion vouchers for a visit to an amusement park, a trillion vouchers each for Prozac and attendance at a sporting event, and so on. AIG and Citigroup would be in charge of making a market in these vouchers, so if someone didn’t wish to buy a car he could exchange the car voucher for cigarette vouchers or any other voucher. But since these vouchers would have an expiry date they would unleash a huge consumption boom, which would temporarily lift the prices of everything and, therefore, achieve the objective of the US economic policymakers of creating inflation and negative real interest rates. (An even simpler solution would be to remove all taxes for two years, or simply to send each American a cheque for a million dollars, but the impact on spending would not be as powerful as with my voucher system.)

With my voucher system, the current interventionist government could even target the bailout of some specific industries that are currently ailing. For instance, it could issue 310 million vouchers, each of which could be exchanged for the purchase of a new car; whereas it would not issue vouchers for goods where demand remains strong – namely, for guns, cocaine, ecstasy, prostitutes, and porno magazines. And if some protectionist flavour was desired – since this would really stimulate domestic capital spending and employment – the government could issue a disproportionately larger quantity of vouchers for the purchase of domestic goods than for foreign goods.

And who would pay for the vouchers that businesses would receive from consumers? Nobody! The Treasury Department could issue bills, notes, and bonds to pay businesses for the tendered vouchers, and have the Fed buy them all. But would nobody really pay for my voucher system? The objective of my voucher system would be fulfilled, which is to create inflation, but at the cost of a tumbling US dollar and collapsing bond prices, as was the case in the 1970s (see Figures 3 and 4).

I may add that a collapsing dollar might lead to a “little too much inflation”–even for the Bernankes and Mankiws of this world! The astute reader will naturally ask what will happen when the economic stimulus arising from the vouchers ends, since they are issued with an expiry date. The answer is very simple: the same thing as occurred after 2007 when the stimulus from easy monetary policies and strong debt growth (inflation) ended: demand collapsed.

But that should be of no great concern to the Mankiws of this world. The government could then issue new vouchers with a higher face value and in higher quantities. So, whereas my initial voucher program would have issued 310 million car vouchers with a face value of $40,000 each, the government could now issue 400 million car vouchers with a face value of $100,000 each. Now, some of my readers may think that I have lost my mind, but macroeconomically there is very little difference between my voucher program, which guarantees to stimulate demand and bring about inflation immediately, and the way the Treasury has recently expanded the fiscal deficit and the Fed has increased its balance sheet (see Figure 5). My vouchers stimulus runs out when the vouchers expire, and the Treasury’s and the Fed’s stimuli run out when these esteemed institutions stop increasing them! But my point is that if a government is determined to create inflation and negative real interest rates, there is really nothing standing in the way of its doing so.

Naturally, both voucher and money stimuli lead to enormous economic and financial volatility. In this respect, I urge my readers to read R.A. Radford’s “The Economic Organisation of a P.O.W Camp”, in Paul A. Samuelson, John R. Coleman, and Felicity Skidmore (eds), Readings in Economics (McGraw-Hill, 1952). (For those people who have little time to read, this is a superb book about economics and contains brief contributions by economists such as Malthus, Marshall, Boehm-Bawerk, Taylor, Hayek, Tobin, Friedman, Samuelson, Schumpeter, Ricardo, Bastiat, Rostow, Kuznets, Burns, Eckstein, Keynes, and Kindleberger, and many more.)

Radford describes how in a prisoner’s camp during the Second World War cigarettes became the principal “currency” and how prices compared to cigarettes fluctuated widely. The Red Cross would make weekly deliveries of cigarettes to the P.O.W. camp and prices would subsequently fluctuate largely as a function of the quantity of cigarettes delivered. When plenty of cigarettes were delivered the prices of other goods would increase; conversely, when the supply of cigarettes was scarce, prices would deflate. Radford concluded that “the economic organisation described was both elaborate and smooth-working in the summer of 1944. Then came the August cuts [in the delivery of cigarettes by the Red Cross – ed. note] and deflation. Prices fell, rallied with deliveries of cigarette parcels in September and December, and fell again. In January 1945, supplies of Red Cross cigarettes ran out and prices slumped still further: in February the supplies of food parcels [to a lesser extent, food also was used as medium of exchange – ed. note] were exhausted and the depression became a blizzard. Food, itself scarce, was almost given away in order to meet the non-monetary demand for cigarettes.”

Radford never won a Nobel prize for his observations about the economics of a P.O.W. camp, but they taught me far more about relative and absolute price movements than did economists at Ivy League schools. When supplies of cigarettes (money) increased relative to food items, prices for food rose more than for cigarettes; and when supplies of cigarettes fell, food prices fell more than prices of cigarettes. In other words, the successful P.O.W. camp hedge fund traders had to constantly adjust their investment position between cigarettes (money) and food (assets), depending on their relative supplies. This is the investment environment I expect for the foreseeable future.

Regards,

Dr. Marc Faber
for The Daily Reckoning

The Frame of Mind of American Economic Policymakers, Part II originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."

A friend of mine, Michael Berry, whose missives I always read, could not have phrased this better than in “Importance of the Individual”, a recent report in which he quotes Milton Friedman (whose views I fully share in this particular instance) in an interview with Phil Donohue

According to Berry, “On February 11, 1979 Milton Friedman took 2-1/2 minutes to explain the critical importance of the individual and choice in the free enterprise system to a doubting Phil Donohue. I wonder what Dr. Friedman would say 30 years later about our current predicament and the role government is assuming in our lives? The individual’s freedom and ability to choose and take risks to create value are, of course, all important life elements and a cornerstone of our country.

“Individual ability to choose and take risk is being suppressed. It is increasingly evident that it is the government that is defining risk and the taking of risk. The sanctity of Moral Hazard has now been repeatedly breached by both recent administrations. We must guard these life elements jealously. Please take time to ponder the Friedman interview.

“Unfortunately in the current partisan atmosphere in Washington the role of the individual and that of individual risk taking is being suppressed. When the President of the United States uses the ‘Bully Pulpit’ to criticize institutions for not ‘playing ball’ (Chrysler debt holders) and forces a CEO to resign (GM’s Wagoner), when a Treasury Secretary and Chairman of the President’s Economic Council team up to run an auto company (General Motors), and when no institution is too large to fail (the other side of individual risk taking) something is seriously amiss. Under the guise of saving the economy, there is a not so stealthy encroachment on the rights of the individual. No one is noticing.

“This is not, ‘Change We Can Believe In.’ It is ‘change we must be wary of.’ Where is Milton Friedman when we really need him? Think carefully about the following interview which was conducted 30 years ago. Another read of Friedman’s ‘Free to Choose’ is in order for all. We pray that Washington will not stray too far.”

Phil Donohue: When you see around the globe the mal distribution of wealth, the desperate plight of millions of people in underdeveloped countries. When you see so few haves and so many have-nots. When you see the greed and the concentration of power. Did you ever have a moment of doubt about capitalism? And whether greed is a good idea to run on?

Milton Friedman: Well first of all tell me, is there some society you know that doesn’t run on greed? You think Russia doesn’t run on greed? You think China doesn’t run on greed? What is greed? Of course none of us are greedy. It’s only the other fella that’s greedy. The world runs on individuals pursuing their separate interests. The greatest achievements of civilization have not come from government bureaus. Einstein didn’t construct his theory under order from a bureaucrat. Henry Ford didn’t revolutionize the automobile industry that way. In the only cases in which the masses have escaped from the kind of grinding poverty that you are talking about, the only cases in recorded history are where they have had capitalism and largely free trade. If you want to know where the masses are worst off, it’s exactly in the kind of societies that depart from that.

So that the record of history is absolutely crystal clear, there is no alternative way, so far discovered, of improving the lot of the ordinary people that can hold a candle to the productive activities that are unleashed by a free enterprise system.

Phil Donohue: Seems to reward not virtue as much as the ability to manipulate the system.

Milton Friedman: And what does reward virtue? You think the Communist commissar rewards virtue? You think a Hitler rewards virtue? Do you think… American presidents reward virtue? Do they choose their appointees on the basis of the virtue of the people appointed or on the basis of political clout? Is it really true that political self-interest is nobler somehow than economic self-interest? You know I think you are taking a lot of things for granted. And just tell me where in the world you find these angels that are going to organize society for us? Well, I don’t even trust you to do that.

Well, for sure you won’t find any angels at central banks around the world and in the economics faculties of universities. I needed quite a stiff drink after reading a Wall Street Journal article by Harvard Professor Gregory Mankiw, who advocates creating negative real interest rates through inflation and seems to have great sympathy for the outright expropriation of savers. Professor Mankiw needs no introduction. His great intellect was revealed on February 1, 2000, dead ahead of the NASDAQ collapse, when he expressed the view in the Wall Street Journal that “when you look at the mistakes of the 1920s and 1930s, they were clearly amateurish. It is hard to imagine that happening again – we understand the business cycle much better.”

The mindset of the US Federal Reserve and of a very large number of economists is perfectly reflected in the views of Mankiw, according to whom, “It May be Time for the Fed to Go Negative” (see Wall Street Journal of April 19, 2009). For the ease of the reader I have added some comments, which will be noted in italics and with a ‘MF’.

Mankiw: With unemployment rising and the financial system in shambles, it’s hard not to feel negative about the economy right now. The answer to our problems, however, could well be more negativity. But I’m not talking about attitude. I’m talking about numbers [MF: He means negative interest rates]… What is the best way for an economy to escape a recession? Until recently, most economists relied on monetary policy. Recessions result from an insufficient demand for goods and services – and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand.

There is no clear evidence that interest rate cuts stimulate lasting employment gains, because “lower interest rates encourage households and businesses to borrow and spend.” If an industry is plagued by overcapacities (the oil and mining industry in the 1980s and 1990s), lower interest rates (interest rates fell throughout the 1980s and 1990s) are irrelevant. (The same applies for autos now.) In addition, interest rate cuts that encourage households to borrow and spend may not help employment in the country that implements such policies (the US after 2001) but instead in another country (China), where production costs are lower and where a large pool of savings is available for capital spending. (Also, it is not consumption that creates prosperity but capital formation.) To his credit, Mankiw recognizes this problem. He writes:

Mankiw: The problem today, it seems, is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools, such as buying longer-term debt securities, to get the economy going again. But the efficacy of those tools is uncertain, and there are risks associated with them…

So why shouldn’t the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3%? At that interest rate, you could borrow and spend $100 and repay $97 next year. This opportunity would surely generate more borrowing and aggregate demand.

The problem with negative interest rates, however, is quickly apparent: nobody would lend on those terms. Rather than giving your money to a borrower who promises a negative return, it would be better to stick the cash in your mattress. Because holding money promises a return of exactly zero, lenders cannot offer less. Unless, that is, we figure out a way to make holding money less attractive.

At one of my recent Harvard seminars, a graduate student proposed a clever scheme to do exactly that. Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10%. That move would free the Fed to cut interest rates below zero.

People would be delighted to lend money at negative 3%, since losing 3% is better than losing 10%. Of course, some people might decide that at those rates, they would rather spend the money – for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn’t a flaw – it’s a benefit. [MF: I think that most people would choose to invest in another country where savings wouldn’t lose 3% per year.]

The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea of a carrying tax on money. With banks now holding substantial excess reserves, Gesell’s concern about cash hoarding suddenly seems very modern.

Silvio Gesell (1862–1930) was a rather obscure economist, but a cult formed around his more outlandish socialist and land nationalization ideas. He was the author of Die Reformation des Münzwesens als Brücke zum Sozialen Staat (The Reformation of the Monetary System as a Bridge to a Social State – read “socialism”).

In fact, I had forgotten about him until Mankiw brought him up, but I remember well how my history teacher in high school – who also had a socialist tick, but was an outstanding historian – discussed him at length in the context of socialism and land reforms through expropriation. (Right throughout the course of history, this has never worked. Also, Gesell’s tax on cash had more to do with soaking the rich than stimulating consumption.)

In 1919, Gesell was called to take part in the Bavarian Soviet Republic by Ernest Niekisch. The Republic offered him a seat on the Socialisation Commission and later appointed him as the People’s Representative for Finances. Fortunately (for the world), his term of office lasted only seven days. After the bloody end of the Soviet Republic, Gesell was held in detention for several months and was later acquitted of treason. Unfortunately, he never had the opportunity to read George Orwell’s Animal Farm – published in 1945 – which refuted most of his arguments for a “social state”.

Regards,

Dr. Marc Faber
for The Daily Reckoning

The Frame of Mind of American Economic Policymakers, Part I originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."

I can see some – albeit very modest – improvement for the US stock market. For one, it appears that the slowdown and problems in other economies, such as the UK (a disaster waiting to happen), Italy, Spain, and Ireland, are even greater than in the US. Also, since numerous emerging stock markets have underperformed the US this year, some money is likely to be repatriated from countries such as India and China, where stock markets are down approximately 40% year-to-date. We should also consider that, as Joachim Fels noted, "Fifty of the 190 or so countries in the world now have inflation running at double-digit rates. Almost all of these are EM economies." In my opinion, some emerging economies – contrary to expectations – could therefore be hit even harder than the US. So, the good news here is that the "bad news" is even worse in some other countries than in the US (though this may be hard to believe).

The media and some market commentators who were "bullish" until late June have noticed recently that we are in a bear market, because the major indices are down roughly 20% from their peak. This is a remarkable achievement in the annals of forecasting and market timing! How many stocks had to drop by between 50% and 99% before the media and some "bulls" who have continued to talk about another upward wave in stock prices being just around the corner, which would supposedly lift the indices to new highs, finally accepted that we are now in a bear market? Don’t forget that when stock market indices made new highs seven months ago, the media and most advisers were exuberantly optimistic – although most stocks were then already in downtrends. Moreover, sentiment figures (bulls versus bears) among individual investors and investment advisers are now heavily tilted towards the bearish side. Whenever sentiment has been this negative in the past, the odds favoured at least a short term rally. Still, I need to warn our readers that since sentiment remained so extremely optimistic between 2003 and 2007 while the stock market rose, it is possible that sentiment will remain extremely negative for a long time while the market continues to decline.

The third improvement I have noticed is that, from a technical point of view, the market has become "quite" (though not extremely) oversold. But again, I need to warn here that the market would now be oversold in the context of a bull market – not in the context of a bear market, during which the oversold condition could last for a very long time. I suppose that Ambac was already oversold at US$70, and where is the stock now? Moreover, at major turning points, markets can quickly reach oversold or overbought conditions and then work out these conditions without large corrections. Let me explain.

In the summer of 1982, US equities had become extremely depressed; they were no higher than in 1964, and were down in real terms by more than 70% from their 1966 "real" high. The Dow bottomed out at 769 on August 9 and, if I recall correctly, the stock market took off on August 18. By September 22, the Dow had reached 951 (up more than 20% from the August low). The two most overbought conditions I have seen up to that time had occurred at the end of August 1982, and then again on September 22. But, thereafter, the market continued to rise: to 1296 in November 1983, to 2746 at the August 1987 peak, and to the recent high of 14,198 on October 12, 2007.

So, I wish to stress that overbought and oversold conditions must always be put in the context of both the primary trend – up or down – and the phase of the bull or bear market in which they show up. Overbought conditions at the beginning of an uptrend, and oversold conditions at the beginning of a downtrend, are meaningless from a longer-term perspective! If we are indeed in a bear market, which is my view – and has been since the summer of 2007, the current oversold position is relevant only from a very short-term point of view.

The fourth improvement I see is that some previously strong stocks and groups such as US Steel (X), Cleveland-Cliffs (CLF), IBM, and the oil sector, as well as the Nasdaq and some of its leaders such as Research in Motion (RIMM), Apple (AAPL), etc, are beginning to turn down. For the market leaders to collapse is an important precondition for a major low. But again, we need to understand that it will take much longer, and far lower prices, before the very strong stocks and sectors (mostly energy-related and materials) that have so far defied the bear market in financial stocks reach a major low.

Since I fully expect the financial crisis to spread into the real economy, I would sell those sectors and stocks that have so far defied the weakness in financial stocks. Another potentially good piece of news is that the current expansionary monetary policies make the stronger companies in an industry relatively stronger than their weaker competitors, which would then be reflected in strongly diverging stock performances. The weak company stocks could decline so much as to make them, at some point, attractive merger and acquisitions candidates for the financially stronger companies. Industry consolidation would in this scenario accelerate and lead to stronger pricing power (and inflation).

The last potentially good bit of news is that oil and other commodity prices may have reached an intermediate top. Should oil prices decline by, say, 20% to 40%, this fact will certainly be broadcasted by the media – as well as by ignorant cheerleaders and people who still don’t regard commodities as an asset class – as great news for the stock market! A relief rally would likely follow. But wait a minute: why would oil prices and other commodities decline meaningfully? Because of a lack of affordability and a weak economy around the world – not just in the US! This would lead to declining demand for raw materials and likely lower prices. (Supplies are unlikely to increase significantly, but they could be cut as a result of war, civil strife, or concerted action by the producers.) However, a weak economy or economic contraction around the world would be unlikely to be favourable for equities and corporate profits.

I need to make one more comment with respect to oil prices and commodities. It is not a strong US dollar that will lead to declining oil prices, as some commentators argue. What will bring about lower oil prices is a collapse of consumer spending in the US and elsewhere in the world. If US consumption collapses, the US trade and current account deficit will be halved and will lead to a drying up of global liquidity. I have discussed this relationship many times in the past and have clearly shown the relationship between the growth rate in Foreign Official US Dollar Reserves and the US dollar. Declining US consumption will be positive for the US dollar and will certainly bring down commodity prices because of lower demand (at least temporarily). But if you really think that such an outcome will be good for stocks, then dream on!

Finally, since the bull market in commodities began, there has been a body of people who have maintained that commodities are not an asset class. Some have even gone as far as to compare gold to washing machines. But consider the following: my dogs and my books are an asset for me, but maybe not to someone else. My dogs protect my house and my books. My books give me pleasure and – so I hope – some modest knowledge. But my dogs would be a liability to someone else if he lived in a secure condo building. (If there is such a thing as a secure condo building!) Also, my books would be useless to an illiterate person, since he would not be in a position to read them. A high-calibre mathematician is likely to be an asset for James Simons of Renaissance fame, but a huge liability in a rescue mission on Mount Everest. Water may be a huge asset if you are lost in the middle of the desert, but it is not an asset when you are standing in the rain without an umbrella and waiting for a date to arrive. So, the first point to understand is that anything can be an asset for somebody at some time, and not an asset for somebody else at some other time. Normally, cigarettes are not considered to be an asset, but in prisoners’ camps during wars, in wartime in general, and in times of hyperinflation, they are an asset – in fact, they replace cash banknotes.

Now, if someone defines an asset class as something that provides a cash flow, commodities may by this definition not be an asset. However, what if asset markets such as equities, bonds, and cash (T-bills) provide a negative return in real terms (inflation adjusted)? The moment when money loses its purchasing power because real interest rates are negative, and because we need to deal with people like Mr. Bernanke, assets such as raw land, commodities, art and collectibles do become a store of value and, therefore, represent a desirable asset class. All I wish to say is that the term "asset class" is extremely difficult to define, and that at different times and in different situations certain things and certain skills become an asset, whereas on other occasions they are useless. But one thing all my readers should clearly understand: when the last ship leaves the port as the enemy approaches, the captain of that ship will accept one kilogram of gold from you to buy your passage. I doubt that he will accept CDOs, derivative contracts, bonds or, for that matter, stock certificates of Fannie Mae or Freddie Mac. (Maybe by then the captain won’t even accept US dollars, because their value could decline precipitously during the voyage.) I may add that, in the financial sector, the last ship may be about to leave.

In sum, I believe that in the next few years the returns from equities will be disappointing (short-term rallies aside), which could cause other asset classes (especially industrial commodities) also to come under pressure. When I look around, I find it hard to identify any asset that is particularly attractive at this point. Therefore, in the absence of anything that promises far superior returns, I am still happy to accumulate physical gold. In democracies, where the leadership is afraid to ask for sacrifices from its citizens and with money printers at central banks, gold would seem to be the only sound currency.

Regards,

Dr. Marc Faber
for The Daily Reckoning
August 6, 2008

Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow’s Gold, one of the best investment books on the market.

Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.

"Fed keeps short-term interest rate at 2%", says today’s big financial headline. Stock market investors loved it. They bid up the Dow 331 points. "The correction is over," they seemed to say.

The Bernanke team knew it would be damned for sending the U.S. into recession if it raised rates. It knew too that it would be damned for allowing inflation out of its cage if it cut them. So it decided to do nothing.

"Although downside risks to growth remain," said a Fed spokesman, "the upside risks to inflation are also of significant concern to the committee."

Here at The Daily Reckoning headquarters we are fans of doing nothing – at least in financial matters. Not spending money, for example, keeps us from going broke. Not investing money often has the same effect. When it comes to money, politics or romance…the sins of omission may cause you to miss opportunities, but the sins of commission get you sent to Hell.

We’ve had our binoculars out for the last couple of days. What we’ve seen is a major correction. Initially, the correction was centered on housing and subprime mortgage finance. Then, it hit stock markets – doing most damage in the go-go markets of the emerging economies. And now, it is leaking into the rest of the financial industry.

"Defaults hurt credit card bonds," reports the Wall Street Journal. Morgan Stanley is said to "freeze client home equity loans," adds Bloomberg.

Everything gets corrected eventually. Total debt to GDP reached 230% in 1931. Total debt probably peaked out a couple of years earlier, but by the ’30s, GDP was falling, while the debt had yet to be liquidated – producing a record debt/GDP figure. Then, in the following correction, the ratio collapsed to 50% by the end of WWII.

But the last quarter century has been a great time to be in the financial industry. Everybody wanted to borrow…or to lend. The debt to GDP figure shot back up to near 300%…as the financiers collected their millions in bonuses. But now, another major correction is underway.

Commodities are correcting too. China announced a slowdown in manufacturing last week. This means less demand for oil, iron, copper and the whole complex of resources. So far, they’re down 10-20%. Yesterday, oil lost another $2.83, bringing the price down to $118 a barrel.

Gold, too, took a beating yesterday. It fell $21, to $886. "Will we ever have an opportunity to buy gold below $900," we asked a few days ago. Now we have our answer – yes. Will we have an opportunity to buy gold below $800? We will have to wait for the answer to that one. But our guess is ‘no.’ Because a bigger correction still lies ahead – a correction of the post-Bretton Woods, dollar-dependent, faith-based monetary system. Stay tuned…

*** We noted yesterday that the Dow stocks are losing money. Taken together, they no longer add value to the economy – they subtract it. The last time this happened, in 1932, proved to be a great buying opportunity.

But now we leave the facts for an opinion…and history for the future. Will 2008 prove to be a great buying opportunity in stocks? We doubt it. Stocks traded as low as 4 or 5 times earnings in ‘32 – because the bull market prices had been corrected. Once knocked down, they could get up and dust themselves off. The difference today is that the stock market hasn’t been knocked down yet. So, it can’t get up – it’s already up. In an earlier, less optimistic age, the collapse of earnings caused a selling panic that made stocks cheap. Now, after a quarter century of rising prices…and an almost religious faith in the Federal Reserve…people read the financial news as though it were the summer weather forecast. Yes, it may be cloudy today, but soon the bad weather will pass and it will be sunny again. Stocks are still expensive.

What investors don’t realize is that the seasons change too.

Our guess is that a few pages have been turned on the monetary calendar too. The dollar has seen fairly decent weather since March. "The worst is over," say the fair-weather forecasters. "It’s clear sailing from here on," they guess. Then, looking at the decline of gold: "See, I told you so," they say.

But here at The Daily Reckoning, we treat our dollars like we treat our salads: there’s no sense in saving them. Not that we have a prejudice against the greenback. We feel the same way about the euro. And the pound. It’s all funny money as far as we’re concerned. In a correction, the real cost of things goes down. Because there are fewer people with the desire and the means to buy them. So, we’d expect the price of gold to go up – since it must become more valuable compared to the things it will buy. That is what happened in the Great Depression; Franklin Roosevelt first confiscated all the nation’s gold and then he raised its price 60% – effectively increasing the money supply the same amount.

Paper currencies, meanwhile, are created and managed by people who have a deep loathing for corrections of any sort. These are the people who set the U.S. government on course for a half a trillion dollar budget deficit this year…and who stand ready to spend $300 billion to bail out America’s over-confident mortgage lenders and over-stretched homeowners. They want to prevent a serious correction in the worst possible way. What’s the worst possible way? Ben Bernanke has already described it. He said he would "drop money out of helicopters" if that is what it took.

We don’t expect to see it raining $100 bills anytime soon. But we don’t expect any serious effort to contain inflation either – as evidenced by the Fed’s decision, yesterday, to do nothing. Instead, one way or another, they will do what Roosevelt did; they will lower the price of the dollar.

"Inflation accelerates; growth stagnates," summarizes Bloomberg.

The country should be listening to the "inflation alert," says the Wall Street Journal.

The latest official tally puts consumer price increases at 5%. But the Dallas Morning News issues a word of caution:

CPI numbers "may not reflect your family’s reality."

Inflation is on the rise; it will get worse. As it gets worse, the dollar will fall against gold.

*** Freddie Mac’s main man is in the news. The captain is being attacked for his role in steering the titanic mortgage lender. This from the New York Times:

"Richard F. Syron, in 2004 received a memo from Freddie Mac’s chief risk officer warning him that the firm was financing questionable loans that threatened its financial health.

"Today, Freddie Mac and the nation’s other major mortgage finance company, Fannie Mae, are in such perilous condition that the federal government has readied a taxpayer-financed bailout that could cost billions. Though the current housing crisis would have undoubtedly caused problems at both companies, Freddie Mac insiders say Mr. Syron heightened those perils by ignoring repeated recommendations.

"In an interview, Freddie Mac’s former chief risk officer, David A. Andrukonis, recalled telling Mr. Syron in mid-2004 that the company was buying bad loans that ‘would likely pose an enormous financial and reputational risk to the company and the country.’

"Mr. Syron contends his options were limited.

"’If I had better foresight, maybe I could have improved things a little bit,’ he said. ‘But frankly, if I had perfect foresight, I would never have taken this job in the first place.’

"Those and other choices initially paid off for Mr. Syron, who has collected more than $38 million in compensation since 2003.

"Now, some outsiders are saying that Mr. Syron and the top executive at Fannie Mae – some of the highest-profile figures in the business world – should be replaced."

Replaced? The poor man will also be harassed by the press and probably hounded by lawsuits. A hanging would be more humane.

*** How’s the war on terror going? We don’t hear very much about it. But it’s the justification for hundreds of billions of spending, not to mention wire-tapping, Guantanamo and water-boarding. You’d think we’d hear more reports from the frontlines…about the battles and casualties. Why not? Maybe no one really cares. The Pentagon has its money. The feds have their new powers. Maybe nobody really thought that terrorism was much of a threat in the first place. Here at The Daily Reckoning, we always considered it just a bugaboo. This just in:

"Study Criticizes ‘War on Terror’; Calls for Law-Enforcement Approach

"The publication of ‘How Terrorist Groups End’ – a thorough new report by RAND, a think-tank with historic ties to the U.S. military – vindicates critics of the ‘global war on terror’ who have argued that a law-enforcement approach to fighting al-Qaeda, rather than a military war, with all the bluntness that wars entail, would have been better for protecting Americans. ‘The report concluded that the administration’s war on terrorism has not significantly degraded al-Qaeda and that the group has morphed into a more formidable enemy,’ writes Ivan Eland, Senior Fellow at the Independent Institute and director of the Center on Peace & Liberty."

Until tomorrow,

Bill Bonner
The Daily Reckoning

Very Modest Good News originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."

Although I don’t always agree with the views of columnist Thomas Friedman, I couldn’t agree more with his criticism of US energy policies. In a recent article entitled "The energy to be serious", he takes Hillary Clinton and John McCain to task for their suggestion that the federal excise tax on gasoline be suspended this summer

According to Friedman, "It is great to see that we Americans finally have some national unity on energy policy. Unfortunately, the unifying idea is so ridiculous, so unworthy of the people aspiring to lead the United States, it takes your breath away.

"Hillary Clinton has decided to line up with John McCain in pushing to suspend the federal excise tax on gasoline, 18.4 cents a gallon, for this summer’s travel season. This is not an energy policy. This is money laundering: We Americans borrow money from China and ship it to Saudi Arabia and take a little cut for ourselves as it goes through our gas tanks. What a way to build a country."

When the summer is over, we will have increased our debt to China, increased our transfer of wealth to Saudi Arabia and increased our contribution to global warming for our kids to inherit.

No, no, no, we’ll just get the money by taxing Big Oil, says Clinton. Even if we could do that, what a terrible way to spend precious tax dollars – burning it up on the way to the beach rather than on innovation.

The McCain-Clinton gas holiday proposal is a perfect example of what energy expert Peter Schwartz of Global Business Network describes as the true American energy policy today: "Maximize demand, minimize supply and buy the rest from people who hate us the most." …

Few people know it, but for almost a year now, Congress has been bickering over whether and how to renew the investment tax credit to stimulate investment in solar energy and the production tax credit to encourage investment in wind energy. The bickering has been so poisonous that when Congress passed the 2007 energy bill last December, it failed to extend any stimulus for wind and solar energy production.

Oil and gas kept their credits, but those for wind and solar have been left to expire this December… These credits are critical because they ensure that if oil prices slip back down again – which often happens – investments in wind and solar would still be profitable. That’s how you launch a new energy technology and help it achieve scale, so it can compete without subsidies… It is so alarming, says Rhone Resch, the president of the Solar Energy Industries Association, that the U.S. has reached a point "where the priorities of Congress could become so distorted by politics" that it would turn its back on the next great global industry – clean power – "but that’s exactly what is happening."…

While all the presidential candidates were railing about lost manufacturing jobs in Ohio, no one noticed that America’s premier solar company, First Solar, from Toledo, Ohio, was opening its newest factory in the former East Germany – 540 high-paying engineering jobs – because Germany has created a booming solar market and America has not. [Germany and Japan have, respectively, 20- and 12-year solar incentive programs in place - ed. note.] In 1997, said Resch, America was the leader in solar energy technology, with 40% of global solar production. "Last year we were less than 8% and even most of that was manufacturing for overseas markets."

The McCain-Clinton proposal is a reminder to me that the biggest energy crisis we have in our country today is the energy to be serious – the energy to do big things in a sustained, focused and intelligent way. We are in the midst of a national political brownout.

At about the same time, John Gapper, writing for the Financial Times, lamented the poor state of US infrastructure in an article entitled "On the pot-holed highway to hell":

"If anyone doubts the problems of US infrastructure, I suggest he or she take a flight to John F. Kennedy airport (braving the landing delay), ride a taxi on the pot-holed and congested Brooklyn-Queens Expressway and try to make a mobile phone call en route. That should settle it, particularly for those who have experienced smooth flights, train rides and road travel, and speedy communications networks in, say, Beijing, Paris, or Abu Dhabi recently. The gulf in public and private infrastructure is, to put it mildly, alarming for US competitiveness…

"Faced with the emptying of the Highway Trust Fund, established in 1956 as the US entered a period of growth and prosperity, Mrs. Clinton suggested cutting its source of funds (which she claimed could be made up by a tax on oil companies)… At times I wonder whether the world’s biggest economy has the will to solve its challenges or will end up wandering self indulgently into the minor economic leagues. I expect it will get serious when the crisis is too blatant to ignore, but it has not done so yet.

"Perhaps this is a bit unfair. Some leaders have recognized the problem for economic development, as well as for safety. They include Arnold Schwarzenegger and Ed Rendell, governors of California and Pennsylvania, and Mayor Michael Bloomberg of New York. The trio have allied to press for the states and Washington to act."

Gapper then quoted Ed Rend, incidentally one of Mrs. Clinton’s biggest supporters, who supported her initiative to suspend the "gas tax" and increase taxes on oil companies (a really bad idea, since higher oil company taxes will curtail exploration). "Dams are in a horrible condition … we have no real rail transport, unlike most nations in the world… Summer delays make flying in America a disaster," Rendell said.

According to Gapper, "…there are lots of ways in which infrastructure inadequacy matters to the US but I would focus on two.

"First it imposes a drag on economic growth. The private infrastructure is poor enough – broadband speed lags behind other countries and mobile coverage is spotty. But much of the public infrastructure is unfit, a fact that was becoming clear even before Hurricane Katrina flooded New Orleans and a Minneapolis bridge collapsed during rush hour last year.

"Second, it presents an awful image of the US to investors and other visitors. The state of transport and communication infrastructure is a symbol of a nation’s economic development and the US is starting to look like a third world country. In fact, scratch that. Many developing countries look and feel better. Of course they are in a different phase of development. The US invested 10% of its federal non-military budget in infrastructure in the 1950s and 1960s as it built the interstate highway system – at the time, the envy of the world. While the US investment has fallen to less than 1% of gross domestic product, China has been matching its double-digit postwar record… Americans may not like the sound of that, but they cannot expect the US to maintain the economic dynamism of the late 20th century in the 21st unless they buckle down. Sooner or later, wishful thinking is going to crash into financial reality."

In a column for the New York Times, Thomas Friedman noted that Americans really "want to do nationbuilding" – not in Iraq and Afghanistan, but in America.

According to Friedman, "We are not as powerful as we used to be because over the past three decades, the Asian values of our parents’ generation – work hard, study, save, invest, live within your means – have given way to subprime values: ‘You can have the American dream – a house – with no money down and no payments for two years.’ …

"A few weeks ago, my wife and I flew from New York’s Kennedy Airport to Singapore. In J.F.K.’s waiting lounge we could barely find a place to sit. Eighteen hours later, we landed at Singapore’s ultramodern airport, with free Internet portals and children’s play zones throughout. We felt, as we have before, like we had just flown from the Flintstones to the Jetsons. If all Americans could compare Berlin’s luxurious central train station today with the grimy, decrepit Penn Station in New York City, they would swear we were the ones who lost World War II.

"How could this be? We are a great power. How could we be borrowing money from Singapore? Maybe it’s because Singapore is investing billions of dollars, from its own savings, into infrastructure and scientific research to attract the world’s best talent – including Americans…

"And us? Harvard’s president, Drew Faust, just told a Senate hearing that cutbacks in government research funds were resulting in ‘downsized labs, layoffs of post docs, slipping morale and more conservative science that shies away from the big research questions.’ Today, she added, ‘China, India, Singapore … have adopted biomedical research and the building of biotechnology clusters as national goals. Suddenly, those who train in America have significant options elsewhere.’"

I have quoted Friedman and Gapper extensively for several reasons. I have been accused of being anti-American, and therefore I wanted to show our readers that there is an increasing body of Americans who are very concerned about their country’s misguided fiscal and monetary policies, which are designed to boost consumption not only of oil, but of everything else as well, at the expense of capital investments, and research and development spending, which are badly needed if the US wants to regain its competitiveness.

Regards,

Dr. Marc Faber
for The Daily Reckoning
June 11, 2008

Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow’s Gold, one of the best investment books on the market.

Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.

Show us a human being…and we will show you why democracy is a bad idea and why contrarian investing is a good one. From the South Pacific this morning comes news that a tribe in Melanesia believes that Britain’s Prince Philip is immortal.

"As unlikely as it sounds, the people of Yaohnanen and surrounding villages worship 85-year-old Prince Philip as a god," reports the Daily Telegraph. "They believe him to be the son of an ancient spirit who inhabits a nearby mountain, on the island of Tanna."

"You must tell King Philip that I’m getting old and I want him to come and visit me before I die," said the white-haired chief, who thinks he is about 80. "If he can’t come perhaps he could send us something: a Land Rover, bags of rice or a little money."

So, you see, dear reader, whether you have a bone through your nose or a Hermes tie around your neck, you want your gods to provide the same things. The difference is that Prince Philip might actually be a good sport and send the savages a few bags of rice. The Fed is almost certainly to disappoint the heathen on Wall Street.

Lately, we have seen the biggest bubbles in debt, delusion and fantasy in human history…more new money and credit created than ever…probably the biggest financial mistakes ever made…the largest drop in U.S. household wealth since the Depression…as many as 15 million negative-equity mortgages…a $57 trillion U.S. government "financing gap"…hundreds of trillions in derivative contracts…

…and now, if you believe yesterday’s trading results, it’s all over. Everything is okay.

The big financial news yesterday began with a remark by Fed chairman Ben Bernanke.

The Fed will "strongly resist" any surge in inflation expectations, he said.

What he means by that is obvious: America’s central bank is going to fight inflation and protect the dollar. At least, so he says.

Investors neither smiled nor blinked yesterday. Instead, they took him seriously. Oil dropped $3. Bonds sold off – sending the yield on the 10-year note back up over 4%. The bonds that sold off most, by the way, were mortgage bonds.

The property market is still weakening. The condominium vacancy rate has risen over 15% – the highest ever. And Floyd Norris of the New York Times says that one out of every four condos built since 2000 is empty. House prices nationwide are down about 13% from the top…but falling more and more rapidly – at a 25% rate in the last three months.

The crisis that began last year seems far from over.

But the big losses, yesterday, were in gold. The yellow metal was down $27 yesterday – to $871. Investors must have figured that gold was doomed – now that the Fed has turned its big guns to an inflation-fighting position.

Now, the dollar will strengthen…(it went up to $1.54 per euro yesterday)…inflation rates will go down…oil will go down – everything will be okay. Really. Honest. No kidding.

But the big question is: how can the Fed really fight inflation, after the biggest jump in unemployment in 22 years? How strongly can the Fed really resist inflation?

We don’t know, but it might not have to. American consumers are buying less from the rest of the world. This leaves less U.S. money in the hands of foreign central banks…and less reason for them to inflate their own currencies. Less demand = less inflation = lower prices. But the price of lower prices is high. It means a worldwide slump…which brings down oil, commodities, gold, employment – and equities. This is not the sort of world in which the Fed raises rates. The Fed’s "fight" against inflation is likely to succeed, in other words, only if it doesn’t need to fight at all.

*** "What’s your solution?" asked a reader in response to Friday’s Daily Reckoning. "Or isn’t there one? If the world’s population is going to implode will that be through mass starvation/dehydration? Or will we run out of beer and all end up killing each other? Or will a terrorist bomb wipe us all out first? Will technology save the day? Isn’t the whole thing survival of the fittest? Is survival of the fittest really the best way of describing it for the human race? Or is it more ‘luck’… Is there a solution, or do we just sit back and watch the world fall apart? "

*** Comes no answer, but more thoughts, from our Pittsburg correspondent, Byron King:

"’Dearer to God are the prayers of the poor,’ go the words to a sturdy old Anglican hymn.

"Well, at $138 per barrel of oil, I think we are about to find out how dear those prayers really are. This, plus the impending agricultural disaster due to low planting levels and other bad weather, will spell impoverishment for large swaths of the American middle class.

"In the United States, the poor and working poor are already marginalized. Now, with the ongoing melt-up in oil prices the middle class is being financially suffocated.

"Just on Thursday and Friday of last week, wholesale gasoline prices went up 33-cents. No typo. That’s 33 cents, in two days. So let’s round it out and add another $500 to the annual gasoline bill to operate one average automobile in the US of A. If you are a two-car household, make that number $1,000. Just from a two-day spike. And that does not count the impact on diesel (killing trucking & agriculture) and jet fuel (killing airlines).

"We are seeing the rapid evisceration of the guts of the U.S. economy. We are seeing the beginnings of an Energy Recession, if not an Energy Depression.

"Back in the Great Depression of the 1930s, it was different. There were ample natural and energy resources, but the factories were closed. There were factories, of course, but the workers were laid off. There were workers, but no one could afford to hire them. The banks had failed due to lack of funds. Overall there was just not enough money priming the pump to get things moving.

"Problem now? The resources are depleted. Many of the factories are gone and not replaced. Indeed, we have a manufacturing-averse culture in many respects. (The faux-environment movement has not helped.) Our educational system has produced a lop-sided labor force, such that there are critical skills shortages all through key parts of the economy (like energy…).

"And there’s too damn much ‘money’ floating around. Actually, it’s just excess U.S. currency in the form of credit instruments. Much of it has floated into the hands of people who are not ‘us.’ A few key resource-producing areas, along with overseas governments and sovereign wealth funds, have control over immense levels of global cash flow. With the rapid run-up in energy prices they are draining the daily capital out of the United States.

"So the overall view is…. not enough resources, not enough productive capacity (esp with energy), not enough skilled labor, and a decapitalized-indebted-illiquid-insolvent financial system that cannot get traction to move ahead.

"And when you don’t move ahead, you fall behind.

"Start praying…"

*** Here at The Daily Reckoning headquarters we have no solutions…and no prayers. (If we have any hope of God’s intercession in our lives, we’re not going to waste it on the economy.) Instead, we sit back and let the world go whither it wouldst. We just try to figure out where it is going…and get a parking place before everyone else shows up!

Until tomorrow,

Bill Bonner
The Daily Reckoning

A National Political Brownout, Part I originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."

A recurring theme of recent issues of this report has been that asset markets will remain extremely volatile. There is a tug-of-war between U.S. economic policy makers – notably, the Fed – who wish to support asset markets in order to stimulate consumption, and the private sector, which is tightening lending standards and bringing about slower credit growth and an economic downturn. The outcome of these opposing forces – both very powerful – will not be known for some time; hence the increased volatility.

In fact, I hesitate to make any forecast because I am faced with the following dilemma: Yes, as Ed Yardeni argues, we are in a recession; and yes, as Ian Scott of Lehman Brothers thinks, corporate profits could conceivably decline by as much as 45% if the United States were to slip into recession. But equally, as these economists and strategists argue, the stock market could move up despite poor economic growth and declining corporate profits. This scenario is particularly likely if the Fed pushes the Fed fund rate towards zero and if "extraordinary" monetary measures are implemented with increasing intensity – and also by non-U.S. central banks, which is now increasingly likely.

After all, anything is possible in a land of plenty (at least of dollars, deficits, and unfunded liabilities) in a country where one out of every 100 adults is behind bars (a total of 2.32 million); where the fear of its legal system is such that – according to a survey of 180 in-house counsel working in five European countries – lawyers working for European businesses would prefer to face a major dispute in Russia or China than in the U.S.; where stock car auto racing is the most popular spectator sport (the National Association for Stock Car Auto Racing holds 17 of the top 20 attended sporting events in the United States); where the movie 10,000 BC, described by critics as a "bombastic bore" and "sublimely dunderheaded", opened in early March at No. 1 with box office earnings of US$35.7 million, ahead of College Road Trip with US$14 million (to be fair, it was also No. 1 in Mexico); and where almost three years into an economic recovery (June 2004), the Fed fund rate was still at 1%!

Yet, I have my doubts about forecasts of the S&P 500 going above 1600 by year end, and of the Dow Jones being at between 18,000 and 20,000 within a year (see above) because, in my opinion, the credit cycle has turned down for good – and when this happens, all asset prices and the economy tend to perform poorly. It would also be extremely surprising if the financial problems that we are now confronted with, which have been fermenting for at least 15 years, were to be solved almost overnight by Mr. Bernanke & Co.! Equally, it would be the first time in my experience that the stock market had made a major low with so many commentators assuring us that a "low" is in place. Not to mention above-average valuations!

Lastly, if money moves out of money market funds into riskier asset markets such as equities, it is likely that interest rates will increase and contain a sharp stock market advance. I therefore maintain my very negative stance towards long-term Treasury bonds.

While I concede that sentiment data is very negative for the near term and so, from a contrary point of view, is supportive of an intermediate low, investors seem to be very complacent and far too optimistic about future corporate profits. A recent Merrill Lynch Fund Manager Survey found that 53% of U.S. fund managers thought a recession in the next 12 months to be "unlikely", up from 35% in February!

For now, I still think that a likely outcome is a "water torture" bear market à la 1973-1974, during which the downtrend was continuously interrupted by sharp countertrend rallies. A rally towards 1450 on the S&P is possible. In mid-March, commodities began to sell off sharply. This is an ominous sign, as it indicates either that the credit crisis is spilling over into asset classes other than equities or that global economic growth will disappoint, or a combination thereof. Last month, I suggested that some "preventive selling of industrial commodities, steel, and iron ore companies might be advisable".

I would like to reiterate here that in an environment of relative tightening of monetary conditions, commodities (including oil and art prices) should also correct meaningfully. This doesn’t change my long-term favourable view about the performance of commodities relative to U.S. financial assets. Should oil prices decline, the prime beneficiaries will be airlines. AMR, Thai International, Singapore Airlines, and Lufthansa could be bought for a short-term trade.

The trend over the past few years has been a relative underperformance of U.S. assets versus foreign stock markets – especially emerging stock markets, a weak U.S. dollar, and strongly rising prices for precious metals and other commodities. This broad trend could change for the intermediate term (three to six months). As indicated in last month’s report, U.S. equities have begun to outperform the MSCI World Index and I expect this outperformance to last for a few months. This doesn’t necessarily imply that U.S. equities will rise, but should they decline further then it will probably be by less than we would expect to see in foreign markets.

Gold remains my favourite asset class, but I wouldn’t rule out a decline in prices to below US$800 before the next upward leg gets under way. As Ron Griess observes, the gold price has tended to bounce off the 300-day moving average – currently at US$741. The U.S. dollar may have reached a selling climax in mid-March and I expect a rally, which may have some legs as dollar shorts will be quick to cover their positions.

Regards,

Dr. Marc Faber
for The Daily Reckoning
April 17, 2008

Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow’s Gold, one of the best investment books on the market.

Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.

Shocking news today…Americans get poorer!

Yesterday, the Dow staged a big comeback – up 256 points. Gold rose $16 too – to $948. And oil hit a new record – just shy of $115. Then, it went over $115 in overnight trading.

So everyone is happy – except those who are short. The goldbugs are happy because gold is headed back to $1,000. Wall Street is happy because stocks are going up. The oil industry is happy…and so are the people who make ethanol…and the people who make hybrid, fuel-efficient cars.

And here at The Daily Reckoning headquarters, in the building with the golden balls, we’re happy too. But we’re happy for no particular reason. As near as we can tell, things are working out just fine – God is in His heaven; the Queen is on her throne; and investors are getting what’s coming to them.

We held our own Council of Nicea last night…about 3AM…after much meditation and drinking. And we came up with a creed. This is the way we think things are now:

I. We believe the Great Moderation is over. It has given way to a period of volatility…a period of Great Flation – of two sorts, both Inflation and Deflation, sometimes warring with each other…sometimes joining forces…sometimes not sure which way they’re going or what they are doing. Deflation, as we all know, is the work of the devil. But inflation is the work, primarily, of America’s own central bank. According to the shadow statistics on the subject (the Treasury no longer reports the numbers), the broadest measure of U.S. money supply, M3, is rising at nearly 20% per year. If output were steady, it should mean price increases of 20% per year too. Maybe more.

So far that hasn’t happened – except in some key areas, which we’ll come to in a minute.

II. We believe that Deflation is doing its work on yesterday’s bubbles – primarily the financial industry and U.S. residential housing. Inflation, on the other hand, focuses on tomorrow’s bubbles – in resources, soft commodities, precious metals and oil.

As for deflation, we see it working on the housing industry, where housing starts are at their lowest level in 17 years…driving consumer confidence down to its lowest level since 1993. The Fed’s Beige Book confirmed that recession was either on the way or already here.

Forbes reports that the worst markets are Miami, Denver, Baltimore and Chicago. We don’t know much about the other places, but until this last bubble, Baltimore property prices had been going down for 80 years. Now, they seem to be back on trend.

The Los Angeles Times adds that prices are being depressed by foreclosed properties – which are dumped back on the market. USA Today says the situation is going to get worse before it gets better. And bankruptcy filings – caused largely by falling house prices – rose 37% last year.

We have little new information from the financial sector – except that Merrill Lynch (NYSE:MER) wrote down another $6-$8 billion. There is also the note in today’s news that John Paulson may have made more money than any human being has ever made – taking home $3.7 billion, thanks to the generous and simpleminded investors in his hedge fund. Paulson bet big that subprime loans would go down. He was right. Now, he’s the Alpha male of Wall Street.

Of course, the whole thing is a terrific fraud, on almost every level. Maybe he took only "2 and 20" of his clients’ money last year. A lucky bet makes the managers rich…but eventually, the clients will go broke. More below…

We’re suspicious of numbers anyway. They mumble. They equivocate. They lie. Mr. Paulson may be the most miserable human being alive, for all we know. Yet, the world is focused on numbers…and on money…and we earn our living writing about it. But what do we really know? What do the numbers really tell us? We can’t really know anything important about Paulson; all we have to look at is the twisted figures.

As for inflation…yesterday, we saw not only a new all-time high for the price of oil…but all commodities are near record highs. Gold has gone up 37% in the last 12 months. Copper – thought to be a measure of economic health – is near its high. In Europe, consumer price inflation is rising at its fastest pace in 16 years.

III. We believe that the combined effect of these flations will be to lower the net worth of the United States of America. Its credits and its debits will be marked down by them both. Most important, the value of its labor will be reduced…so that Americans will be better able to pay their debts and compete (given their skills and capital formation) on the world market. (Keep reading…the figures are shocking…)

IV. And we believe that this is the way capitalism is s’posed to work – people get neither what they want nor what they expect, but what they deserve. Americans have been on top of the world for more than half a century. They have gotten ahead of themselves…they’ve challenged the gods. They have tried to do things that mortals cannot do – live beyond their means and remake the rest of the world in their own image…on borrowed money, no less. They need to be taken down a peg.

But wait, you’re probably wondering…how come Americans can’t stay on top of the world for another 50 years? Well, no law says they can’t. And maybe they will…but not before they’ve been whacked hard enough to make them change their ways. If they’re going to continue spending money at the present rate, they need to figure out some way to get more of it. Almost certainly, they will have to cut back instead. But that’s what this trend is all about – cutting back Americans’ wages, debts and spending power. And they hardly notice!

All those trillions of dollars they sent overseas represent claims on the U.S. economy…on its wealth…on its treasure…on its resources and productive capacity. But every day that the dollar goes down, those dollars buy less. Meaning, Americans’ debts go down.

Of course, their earnings go down too. Since the end of the 19th century, Americans have earned more than any other group. But at today’s dollar/euro (EUR) exchange rate, many nations are already much richer than Americans. The average American earned about $38,000 last year. But the average person in Switzerland earned $64,000. In Denmark, the average salary was $62,000. In Norway, Luxembourg and Germany all had average salaries around $60,000. The Belgians earned an average of $47,000. And the French…yes, dear reader…the frogs are now richer than Americans. The average Frenchman earns $42,000 per year. How’s that for divine comedy? How’s that for taking the starch out of the flag? In the measure that really counts – money – the French are ahead of Americans by a substantial margin.

Oh la la…

Still, we are happy here at the building with the golden balls…and we end on an optimistic, uplifting note: Rome reinvented itself several times – and managed to stay on top of the ancient world for at least five centuries. But each renaissance was a bloody affair – marked by civil war, revolution, slave uprising, barbarian invasion, bankruptcy and inflation. Augustus took power after defeating Mark Antony and Cleopatra at the battle of Actium. Then, he had his cousin (Ceasar’s son by Cleopatra) executed and solidified his control by murdering 100 Senators.

We know this will sound attractive to many readers.

*** The latest news tells us that New York’s economy is being helped by a massive influx of tourists from Europe. The Big Apple may seem expensive to most Americans…but to Europeans, it has become a lot cheaper.

*** Finally, the mainstream financial press is finally catching on to hedge funds; they’re a rip-off. This from Forbes:

"At first glance, hedge funds appear to load management contracts with incentives to encourage good performance and to keep managers’ interests in line with investors’. But in practice there is no way to encourage excellence without making scamming profitable as well…

"According to Foster and Young, investing in a hedge fund is like buying a ‘lemon’ – a car with hidden flaws. ‘This is a potential "lemons" market in which lemons can be manufactured at will, and the lemons look good for a long time before their true nature is revealed.’

"While numbers are imprecise because reporting is light, there are more than 10,000 hedge funds today controlling about $1.9 trillion in assets, compared with more than 8,000 mutual funds with $11.7 trillion in assets.

"The typical actively managed stock-owning mutual fund charges annual fees of about 1.3% of the investor’s holdings, while many passively managed index-style mutual funds charge 0.2% or less. Compared with this, hedge fund fees are very high, at 1% to 2% of assets and 20% of profits.

"If the market returned 8%, a mutual fund matching it would return 6.7% to 7.8% after fees were paid. A hedge fund with the same results would return 4.4% to 5.4% after fees.

"To offset these charges, hedge funds need dramatic results, but research indicates they have not been able to deliver over the long term. A 2007 study of 300 hedge funds by two University of Texas finance professors, John M. Griffin and Jin Xu, found that, from 1980 through 2004, hedge funds outperformed mutual funds by 1.4 percentage points a year. But that was before fees were taken into account. Moreover, the average was driven up by the tech-stock bubble of 1999 and 2000; otherwise, hedge funds did no better than mutual funds.

"In [a] hypothetical example, a fund manager named Oz sets up a $100 million hedge fund with the goal of earning 10 percentage points a year above the 4% annual yield of one-year government bonds. The fund will run for five years and charge a management fee of 2% of assets and an incentive fee of 20% of any profits that exceed the bond yield.

"Oz creates and sells a series of ‘covered calls’ and sells them for $11 million. Each call is a stock option that will pay the investor who bought it $1 million if the stock market rises by a given percentage. Using historical information, Oz figures there is only a 10% probability the market will rise that much. If it does, the hedge fund will be virtually wiped out by being forced to pay $111 million to the call owners. If it does not, the fund will pay nothing – and the $11 million received from the call buyers will be profit.

"Oz now has $100 million received from his investors, plus $11 million from the options sales. He invests the $111 million in risk-free U.S. Treasury bills earning 4%. After a year, the fund thus grows to $115.5 million. To his investors, this is a 15.5% return on their original $100 million.

"Oz earns his 2% management fee on the $115.5 million, plus 20% of the return exceeding what came from the 4% Treasury yield – or 20% of $11.5 million.

"There’s a 59% chance this process can continue for five years without a market downturn annihilating the fund, allowing Oz to collect $19 million in fees, as compounding makes the fund grow larger and larger. If the market does crash, Oz can close the fund, leaving the investors with devastating losses but keeping the fees he’s been paid to that point.

"This simplified ‘piggy-back strategy’ involves no borrowing, or leverage. A real-world manager could inflate his incentive fee by borrowing money to increase the size of his bets, though that would deepen the investors’ losses if things went wrong.

"The bottom line is that Oz’s investors, who don’t know what he is doing, may well believe his market-beating results come from brilliant stock picking or other wizardry. In fact, anyone could set up this simple strategy. Moreover, the investors are in the dark about the risks they are taking. They might well assume that if they make in excess of 15% one year, they might lose 15% in another. In fact, there’s a 10% chance they will lose more than 95% of the money they put in."

Until tomorrow,

Bill Bonner
The Daily Reckoning

A “Water Torture” Bear Market, Part II originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."

"The greatest difficulties lie where we are not looking for them!"

The above observation was penned by Johann Wolfgang von Goethe and may be very prescient in today’s economic and financial conditions.

Let us assume that the unthinkable happens: China’s economy slows down sharply, or even contracts – and there are reasons why it could. Commodity prices slump and bring about economic hardship in the resource-producing countries of the world. In turn, these countries’ imports of capital and consumer goods from Europe and Japan decline.

We would then have the perfect setting for a global economic contraction with dire consequences for corporate earnings and asset prices.

Now, I concede that this scenario is not very likely to occur. However, on a recent visit to Dubai, I could see how it might unfold. I have been traveling to the Middle East since 1977, and I experienced first hand the oil boom of the late 1970s and the collapse in equity and real estate prices when oil prices fell in the early 1980s. About three years ago, on a visit to the Middle East, I felt that the gigantic equity boom would come to an end.

In 2006, most of the Middle Eastern stock markets declined by 50% or more, though the economies didn’t suffer. Yet, over the last three years, it has seemed to me that there is something not quite right about the enormous construction and economic boom that Dubai and other Middle Eastern countries are experiencing. (The world’s tallest buildings are going up there….) What if oil prices were to decline? But why would oil prices decline? Obviously, oil prices would decline because of diminished demand for oil from China and other rapidly growing emerging economies.

But why would demand for oil from China slow down or decline? Obviously, because of an economic recession! The assumption that the Chinese and other emerging economies will continue to expand rapidly may prove to be very deceptive. In recent years, the US has experienced a credit boom and China has had a capital spending boom. Both could come to an end at about the same time! I also wish to stress that there is enormous connectivity between all the world’s economies and that it would be wrong to assume that the present financial crisis, whose epicentre is the United States, couldn’t be followed by financial and economic crises elsewhere.

Also, if the Dubai boom was an isolated event, I wouldn’t be particularly concerned. But everywhere I travel I am left with the uncomfortable feeling that the current boom is surreal and unsustainable. The INDABA – the annual conference for natural resources professionals – which I attended earlier this year in Cape Town, has become a huge circus reminiscent of the consumer electronic shows held in Las Vegas in the late 1990s.

And whereas I have a relatively positive view of commodities, I doubt that all these mining executives (predominantly promoters and liars) will make as much money as they hope to, simply because exploration and mining development costs are soaring. Every major city around the world is also experiencing a huge condo and office construction boom, and in resort areas there are enormous developments of secondary homes.

Should the financial sector contract, as I believe will occur for several years, will all these new offices find tenants? I also wonder if all the condo and second home buyers are aware of the maintenance costs of their units and that in over-supplied markets prices can decline sharply.

Lastly, I think that investors fail to appreciate fully the process of deleveraging after a period of accelerating credit growth. In a credit-driven economy, a deceleration of credit growth will depress all asset prices and tip the economy into recession. In this respect, I am particularly surprised that analysts still expect S&P 500 earnings per share to increase to above US$110 in 2009.

Over the past few months, I have discussed corporate profits a number of times and shared with my readers my concern that we are in the midst of an earnings bubble, which has been driven largely by an explosion of financial sector earnings.

Richard Berner, chief economist at Morgan Stanley, recently published an excellent study entitled "Downside Risk for Corporate Profits", in which he opines: "I think the earnings outlook will disappoint.

"The US economic outlook has darkened and fading operating leverage, dwindling pricing power, and deteriorating credit quality will squeeze margins. Despite the benefit of a weaker dollar, slower growth abroad seems likely to tame the overseas earnings boom" (Morgan Stanley Research North America, US Economics, March 17, 2008). In

Berner’s view, "the combination of slower growth and high operating and financial leverage in Corporate America made a contraction in earnings unavoidable even if the economy skirts recession". (He is referring here to the corporate earnings decline in the fourth quarter of 2007.) "Lower marginal but higher fixed costs have increased operating leverage. Corporate America’s ability to exploit that leverage propelled earnings to record levels when growth was healthy. Strong increments to revenue went straight to the bottom line…. But leverage – both operating and financial – works both ways. Slower growth means that operating leverage is working in reverse, with decreases in revenues going right to the bottom line."

Berner’s two principal concerns about US corporate profits relate to "operating leverage" and the fact that the "strength of overseas earnings" is about to be "challenged". Operating leverage is at present far higher than in the 1990s, which, according to Berner, could mean that "a deeper recession, especially one that spreads abroad, would promote a much more serious profit squeeze."

Berner shows that overseas earnings have increased from 15% of overall earnings 20 years ago to 31.5% at present, as "growth abroad – and the higher oil price that comes with it – are powerful engines for US earnings". I may add that a weak dollar is another extremely powerful driver of overseas earnings as a percentage of total earnings. Also, that "growth abroad – and the higher oil price that comes with it – are powerful engines for US earnings" supports my view about the extreme connectivity we now have between economies in the global economy.

According to Berner:

"[T]here’s also a darker side to earnings from abroad. I worry about the potential for a vicious circle in transatlantic earnings. The US earnings downturn is already spilling over into weaker earnings abroad, especially in Europe. NIPA data show that US earnings remitted abroad in last year’s third quarter declined by 7% from Q3 2006. No doubt such weakness was a factor in our European strategy team’s recent earnings downgrade; they expect a 16% plunge in European earnings this year compared with the consensus forecast of a 7% increase. The impact of the US earnings downturn on Europe likely will be significant: US direct investment data suggest that about 2/3 of our payments abroad go to Europe.

"Such payments, which are earnings of US affiliates of foreign companies, crashed in the last recession – from a peak of $66 billion in Q1 2000 to a loss of $24 billion in Q4 2001. And for European companies the strength of the euro is a massive headwind: A 13% appreciation of the euro has magnified the earnings downturn in euros for European companies’ US affiliates [as it has magnified US overseas earnings – ed. note). Together with tighter financial conditions, I’m concerned that weak earnings at European companies could contribute to a sharp deceleration in capital spending and in European growth. That would complete the circle, because it would also hurt US earnings abroad. About half of those overseas earnings originate in Europe."

I have pointed out above that there is now a much higher economic and financial connectivity in the world than has previously been the case. However, I have to confess that I hadn’t thought about, and fully appreciated, how weaker US growth, manifested as declining profits in the United States, would affect the affiliates of foreign companies, which in turn would lead to lower US overseas earnings. Richard Berner’s analysis is very perceptive! Also, I doubt that European stock markets have fully discounted the 16% plunge in 2008 European corporate earnings that Morgan Stanley has estimated!

Berner concludes his exposé of US corporate profits with the following – very politely phrased – remarks:

"Against this backdrop, what’s really perplexing is that Wall Street analysts don’t think that a weak 2008 will cast doubt on the vigor of next year’s results. On the contrary, in what I think is fundamentally flawed logic, they have maintained the level of their 2009 estimates where they were, so that downward revisions to 2008 earnings actually boost the 2009 growth rate. Street estimates for 2009 S&P 500 earnings growth have been revised up to 15.5% from 14.7% at the beginning of January. By comparison, we expect a 5.9% increase in 2009 after-tax economic profits that would leave the level below that in 2007."

As an aside, a friend of mine, a very savvy and keen observer of economic and financial trends who doesn’t mince his words, calls what the Street has done with 2009 S&P earnings estimates "criminally insane". I agree. After all, illusion is one of the most pervasive realities of life!

Regards,

Marc Faber
for The Daily Reckoning
April 16, 2008

It’s becoming very clear with each passing day that the U.S. economy is headed for an iceberg… and over the next 12 months…and despite all the bank write-downs, market bombs and "bailout" talk already…there are at least five more devastating new financial shocks ahead.

Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow’s Gold, one of the best investment books on the market.

Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.

What a mess!

In England, as in America, consumers are caught between the hammer of inflation…

"Prices soar at the fastest rate for 17 years," says a Daily Express headline.

…And the anvil of deflation…

"House prices fall at fastest rate since 1978," proclaims the Guardian, with the BBC adding that U.K. housing gloom is "the worst in 30 years."

Meanwhile, over in the financial sector, the Globe and Mail says the financial industry in London "could lose 40,000 jobs."

But here at The Daily Reckoning headquarters in London – in the building with the golden balls on the roof, just over Blackfriars Bridge, famous as the spot where Italian banker Roberto Calvi hung himself – we can step back and take the long view.

Prices rise. Assets fall. But what really hurts this time is that the price of an hour of Anglo-Saxon labor (which is all most Americans and Englishmen really have) is going down. (More about that later in the week…)

Do Americans care what happens to the Brits? Not particularly. Unfortunately, the two countries are both in the same boat…both had been sailing along so happily in the sloop: the "Anglo-Saxon" Economic Model. Now, they’re taking on water. It’s all hands on the pumps!

That is to say, both Americans and Brits borrowed too heavily. Now, the time has come to pay back…and no one is very happy about it.

Foreclosures in the United States were up in March, as expected. Bloomberg tells us they rose 57% "as homeowners walk away."

They’re sure not driving away…they can’t afford to!

Oil hit a new record yesterday. At $114 it has never been more expensive. This is another way of saying that Americans and Englishmen have to work longer to buy a gallon. Gasoline is about $2.88 in New York. In old York, it is more like $10 a gallon.

"We’re not producing enough oil," says Gordon Brown, Britain’s CEO.

In fact, we’re producing more than ever before. We’re producing so much…we may never again be able to produce so much. And still the price is rising.

"Russian oil production is peaking," says our man on the case, Byron King. His source is the Financial Times, reporting:

"Russian oil production has peaked and may never return to current levels, one of the country’s top energy executives has warned, fuelling concerns that the world’s biggest oil producers cannot keep up with rampant Asian demand.

"Leonid Fedun, the 52-year-old vice-president of Lukoil, Russia’s largest independent oil company, told the Financial Times he believed last year’s Russian oil production of about 10m barrels a day was the highest he would see ‘in his lifetime’. Russia is the world’s second biggest oil producer."

Bryon elaborates: "He wears the Red Star, I suppose. So you can trust him, right?"

"Most of the Western Siberia oil fields were discovered in the 1950s, 1960s and 1970s. Those fields are now in terminal, irreversible decline even with all the able assistance of the likes of Schlumberger and Baker Hughes. So maybe there was another reason that Putin stepped down as President? There are no coincidences, comrade. Old Russian saying goes, ‘Quit while you are ahead.’

"The genius behind much of USSR oil production was Nikolai Baibakov, who just died on March 31 at age 97. His post-WWII leadership of the Soviet oil industry led to discoveries that fueled the USSR, and later Russian Federation.

"Sic semper petroleos Russkoye."

But let’s not get distracted. So what if oil output is falling?

Ah, dear reader, you’re torturing us with questions like that.

Don’t you know that the whole machinery of Western industrial civilization depends on cheap oil? And don’t you know that we now have to compete for every drop – with the communist Chinese, for example. Yes, their demand for the black goo is rising nearly 5% per year. And now that we’re not actually producing more and more each year, this extra demand…combined with monetary inflation…works on the price like a booster rocket – sending it into orbit.

But is this cycle over? Has the price of oil – which has gone from under $40 in 2001 to over $100 in 2008 – run its course? Is the bull market over?

*** "It doesn’t look like the party is over just yet," says colleague Chris Mayer. "Since January 2001, you can explain the move in the price of oil largely as a function of the increasing money supply. As the amount of money grows, the price of oil rises. In fact, almost 87% of the move in the price of oil can be explained by the increase in money supply…."

As we’ve been saying – and we aren’t the first – inflation is a monetary phenomenon. Inflation that pushed the price or rice to another record high yesterday…and sent gold back up over $930.

But what does this imply about the price of oil going forward?

"Given that we are still in the midst of a credit crisis of sort, is seems unlikely the Fed will tighten money in any way at all," Chris continues. "That leaves a clear path for the price of oil and commodities to continue to rally in nominal terms…"

Chris goes on to point out that oil is no longer merely a U.S. story. The rest of the world is uses more and more of it too. As a nation gets richer…its people use more and more oil…until it reaches a peak …and then oil consumption levels off. That’s why people in Britain drive Skodas instead of Chevrolets. They have reached a level of energy maturity…in which per capital consumption tends to stagnate below 20 barrels per person per year. U.S. energy consumption has leveled off at 25 barrels per person. Hong Kong, South Korea and Japan all have leveled off at about 15 barrels per person.

But China and India – the world’s two largest countries – "are only beginning to consume oil at any meaningful level," Chris notes. They’ve got a long way to go – with huge jumps in the quantity of oil used – before they get anywhere near the levels of the developed world.

"The price of oil has room to run yet," Chris concludes, "in part because of the growth in money supply and in part because of pressing international demand. Second, even if we already saw oil production peak, history says that prices won’t retreat by much over the next several years. And finally, the capital spending boom by the big oil companies is just getting started, which is great news for investors in oil field services companies."

*** Of course, increases in money supply don’t affect ONLY the oil industry. We mentioned rice – which hit a new record yesterday, too.

If gold goes up in price, hardly anyone cares or notices. Oil, too, is something most people can live without. But food?

All over the world, food prices are causing havoc. Riots have broken out in Haiti, Indonesia, the Philippines, and Cameroon – because basic food staples…rice, wheat, corn, soybeans…have become so expensive.

Why are food prices high?

Normal agricultural cycles, is one reason we gave yesterday.

Another is the increasing worldwide demand.

Here’s a third reason – biofuels. On Monday, Britain passed a law requiring that 2% of fuel come from plants (actually, all of it is believed to come from plants…but oil, gas and coal have had millions of years to compress and ferment.) Since Britain doesn’t produce enough biofuel to meet the quota…she actually has to import the stuff on ships from America. Not only does it take more energy to produce the fuel than it generates…the Brits add the cost of shipping it across the Atlantic. But as we keep saying, there’s no problem so awful that politicians can find a way to make worse.

Until tomorrow,

Bill Bonner
The Daily Reckoning

A “Water Torture” Bear Market, Part I originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."

If a shift from low volatility to high volatility signals a change for the worse in the macroeconomic outlook, then the collapse in the yield of short term US Treasury securities is a symptom of the current credit crisis, which has infected all the sectors of the credit market save the highest quality credits.

At the same time, the sharp decline in the yield of ten- and 30-year Treasury bonds and the collapse of lower-quality bond prices seem to indicate that a bad deterioration in US and world economic conditions is about to occur. Since, according to Philip Isherwood, equities tend to perform poorly when volatility is high, cash and bonds would seem to be a good alternative. But, stating his case in favour of US equities on CNBC, a US money manager made the comment that "money in cash is also at risk". This is certainly true for bank deposits, CDs all structured products, and even money market funds, because the return of capital is uncertain. In the case of Treasury securities, "money is also at risk" but for different reasons.

In the case of Treasuries, the return of capital won’t be a problem for now, but I suppose that with a yield of less than 2% on two-year, 3.7% on ten year, and 4.5% on 30-year Treasury securities, the risk is that inflation (not that published by the government, but the cost of living increase for the median household), which is already higher than these yields, will over time completely eat away the purchasing power of the principal, including the interest.

I hope my readers understand the problem of interest rates, which are artificially low and below the rate of inflation. This forces investors, including individuals, institutional investors, and state and private pension funds, into risky investments, which as we have now seen can also lead to widespread losses. In fact, the losses are now so large that they threaten the entire financial system. I estimate that, when all is said and done, the losses experienced by the financial sector and investors brought about by Mr. Greenspan’s and Mr. Bernanke’s irresponsible monetary policies will exceed several trillion US dollars if we add up the combined capital losses on homes, nongovernment bonds, and equities.

Expressed in Euros or gold, the total wealth of the US has already shrunk by at least 40-50% since 2000. I don’t have a high regard for any government (except, possibly, that of Singapore), but the most destructive course a society can embark upon is to appoint academics to positions of responsibility. A problem of artificially low interest rates that is seldom discussed is that many individuals depend on interest income in order to meet their living expenses. Equally, pension funds depend on a certain annual income to meet their present and future liabilities. Moreover, high interest rates provide investors with a cash flow, which can cushion downturns in asset values. Say, an individual or a pension fund owns a balanced portfoli 50% in equities and 50% in fixed income securities of various maturities. Let’s assume that, in a given year, the stock portfolio declines by 20%. If interest rates average 10% on the fixed income portfolio, the total loss on the portfolio will "only" be around 10%.

Moreover, the cash flow from the fixed income portfolio can be reinvested in equities. But what if the yield on the fixed income portfolio averages only 3%? Obviously, the opportunity to make up for the losses on the stock portfolio by investing the cash flow and averaging down diminishes. And what if the annual cost-of-living increases average 5% or more? In this case, the purchasing power of money will rapidly vanish. Moreover, because of negative real interest rates, consumer price inflation will accelerate, as was the case in the 1970s. At the same time, the "real" spending power of households whose income depends on fixed interest securities will be cut and their standards of living will decline.

My friend David R. Kotok, chairman and chief investment officer of Cumberland Advisors, writes regular insightful comments on the US financial market. Recently he stated: "We still have to deal with dysfunctional credit markets. The Fed must persist in their work of creating liquidity. Only time and transparency will relieve the problem of insolvency. That process is working, too. It takes time and it does and will succeed. Remember, there are no examples of Depression in economic history where stimulus was applied and where the inflation-adjusted interest rate was brought to zero by the central bank. That is the condition in the US today. In sum, stimulus works."

Well, David, on this one I must disagree with you. I know many economies where monetary and fiscal stimulus was applied and yet they still went into depression. In all these economies, the inflation-adjusted interest rates were not only brought down to zero but, in fact, significantly below zero. The failed experiment by John Law with paper money in France at the beginning of the 18th century ended with a depression, and money printing in Germany between 1918 and 1923 brought about total impoverishment of the German working and middle class. Latin America went through extremely poor economic conditions in the 1980s. (In Argentina, car sales declined by more than 50% between 1980 and 1988.)

However, in all these instances, the depression wasn’t accompanied by nominal price declines but by hyperinflation and collapsing asset prices, GDP, and standards of living in real terms. In fact, I know of two little empires that, as a result of excessive monetary and fiscal stimulus, went bankrupt and ceased to exist: the Roman and Spanish empires.

Admittedly, these empires’ rulers weren’t as smart as our present-day leaders of Western democracies….

Also, I was pleased to hear that Robert Mugabe (another academic with several degrees from Oxford and an honorary degree bestowed on him by China’s Hu Jintao "for his brilliant contribution to international diplomacy and peace") has offered Mr. Bernanke a teaching job at the University of Harare. This will provide him with a first-hand opportunity to study the devastating impact of excessive monetary and fiscal stimulus on a society.

So, to a large extent, I agree that "money in cash is also at risk", because there is the risk either of default or that money’s purchasing power will decline. Also, I am beginning to wonder for how much longer buyers of ten- and 20-year Treasury bonds will accept their low yields, which are now below the cost-of-living increases and below nominal GDP. The poorly delivered, contradictory, and incoherent statements made by Mr. Paulson and Mr. Bernanke at a recent Senate hearing didn’t provide much comfort to holders of US fixed interest securities. Not surprisingly, gold has more than doubled since Bernanke was appointed Fed chairman, while the yield on 30-year US government bonds is higher now than before the January 125 basis points Fed fund rate cuts.

Surely, the Fed can cut the Fed fund rate to zero. But this doesn’t mean that longer-dated bonds will rally. If inflation were to accelerate further, rate cuts would inevitably lead to higher long-term rates and capital losses on long-term bonds – particularly if the dollar weakens further! In other words, the Fed can bring down short-term interest rates, but it has little power over the longterm bond market. I may add that one of the problems of hyperinflating economies is that the long-term fixed rate bond market ceases to exist.

I should like to introduce one more thought. Throughout most of the 1970s interest rates were below the rate of nominal GDP growth and negative in real terms. So, what happened? Inflation accelerated, bond yields soared from 6% in 1970 to above 15% in 1981, and the US dollar tanked. After 1981, we had for most of the following 20 years bond yields that were above both nominal GDP growth and the rate of inflation (positive real interest rates).

What happened? We had a lengthy period of disinflation. Also, because real interest rates were particularly high in the early 1980s, we had a huge US dollar rally between 1980 and 1985. After 2001, we again had interest rates that were below both nominal GDP growth and cost-of-living increases, which led to the unprecedented credit inflation we experienced between 2001 and 2007 and the subsequent historic bust.

Now, let us assume that market participants begin to believe in the nonsense Mr. Bernanke has been coming out with concerning "money printing" and "dropping dollar bills from helicopters" in order to stabilize asset markets and avoid economic downturns. They will begin to realize that he is the messiah of the gold bulls and the arch-enemy of sound money.

What will investors do? They will dump bonds and the US dollar en masse. In this context, it is interesting to note that recently, on very poor economic statistics, bonds didn’t rally but sold off. The Institute for Supply Management’s non-manufacturing index, which is representative of almost 90% of the US economy, fell in January from 54.4% to 41.9%. (A reading of 50 is the dividing line between growth and contraction, and the index has averaged 57.6% since its inception in 1997.) January retail sales – closely scrutinised – were a disaster and confirmed my view that US economic statistics published by the government misinform the public about the true state of the economy.

How can January auto retail sales increase by 0.6% when volume sales were down 6% month-on-month? According to David Rosenberg, in addition to declining sales at department stores (down in three of the last four months), sporting goods and book stores, furniture and building materials stores, sales at electronic stores were down 1% in January on top of a 2.5% slide in December, which represents the worst back-to-back performance since the 1990 recession. According to Rosenberg, the "bottom line is that the cyclical components of retail sales – autos + clothing + furniture + electronics + sporting goods + building materials + department stores – were down 0.1% in January.

By way of comparison, spending on gasoline, food and health care rose 1.1% collectively for the month."

The poor state of the economy is reflected by the collapse of the ABC News/ Washington Post Consumer Comfort Index and its various components. The personal finance component is now lower than it was in 2002. Also, the University of Michigan index of consumer sentiment collapsed in January to its lowest level since 1992. According to Rosenberg, "consumer sentiment is now at a level that is telling us that we are not on the eve of a recession but are rather already several months into the downturn".

As I have noted in earlier reports, the US economy is already in recession in real terms, but this fact is obscured by the government’s grossly understating price increases throughout the economy. Despite, in my opinion, horrible economic statistics (in real terms), the Fed needs to be very careful not to disturb bond holders by "printing too much money" (electronically), which – aside from the collapse in lowerquality bonds that had already occurred – would also lead to a rout in long-term government bond prices. At the same time, the US must be increasingly careful about its budget deficits and about bailing out the entire financial sector, which is loaded with crappy paper.

Otherwise, Treasury securities will reach "junk status" sooner than I had expected. But I can very confidently predict that, in the long term, US debt will become "junk"!

So, whereas under a sound monetary regime high-quality bonds would be – like utilities – a candidate to outperform, under a central bank that lacks any monetary discipline they are a rather dangerous investment. But this isn’t to say that, at some point in the current downturn, distressed lower-quality bonds won’t provide a great buying opportunity.

Regards,

Dr. Marc Faber
for The Daily Reckoning
March 05, 2008

Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and author of Tomorrow’s Gold, one of the best investment books on the market.

Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has long specialized in Asian markets and advised major clients seeking bargains with hidden value, unknown to the average investing public.

The banks face "challenging conditions," says Fed governor Donald Kohn. Many are watching their revenues decline as debtors fail to pay up, while the value of their collateral goes down.

Bankruptcy filings are going up, reports the LA Times, which it regards as a "grim omen." Delinquencies in Alt-A debt, a step above subprime, are rising. Car and truck sales were down 10% in February; both Ford (NYSE:F) and GM (NYSE:GM) say they’re cutting back on production.

Is the United States in recession already? Yes, says Warren Buffett. Whether it is technically in a recession or not, we don’t know. But it hardly matters. Across the board, indicators are signaling a slumpy economy. We’re just waiting for the details – how slumpy? And for how long?

The Fed’s remedy is to lend the banks more cash on better terms. The smart money is betting that Bernanke will cut rates again – a sixth time – this month. Not only that, but traders are looking for a big cut – 75 basis points.

Bernanke insists the economy is not well and needs the kind of medicine the Fed usually dispenses. But remember, the Fed is not exactly a U.S. government agency – as if that would be any comfort. It is a cartel of big banks, which regularly conspires to set the price of credit at a level that is agreeable to its members.

Of course, the Fed has a duty to the U.S. government…and to the American people…too. It is a duty that has evolved over time, from supposedly protecting the value of the U.S. dollar to supposedly maintaining full employment. The prevailing economic theory is that you need a steady rate of inflation to keep the factories humming and the shops full, so these two goals were never compatible. Now, faced with real and present danger on both fronts – rising unemployment on one side…rising prices on the other – Ben Bernanke has left no doubt as to which direction he will go. He’s fighting the slump.

Damn the inflation torpedoes! If his actions also help the big banks, by moving their losses onto the public (in the form of higher consumer prices), well, so much the better.

Yesterday, we felt a little sorry for Ben Bernanke. He’s getting blamed for everything…while his predecessor, Alan "Bubbles" Greenspan collects huge fees for kibitzing. Yesterday’s reports from Wall Street said it was Bernanke’s fault that stocks fell. Apparently, his recent remarks have not been upbeat enough. The former professor of economics at Princeton is not as good at obfuscation as the man who preceded him; but he’ll get the hang of it. Then, Ambrose Evans-Pritchard, writing in the Telegraph, branded him a failure. The Fed’s rescue attempt isn’t working, he says.

Today, it gets worse. Not only are the Fed’s rate cuts not working – they’re actually ‘doing more harm than good,’ says a report on MarketWatch. While this is undoubtedly true, we don’t like to see the press gang up on poor Ben.

Here at The Daily Reckoning, we always rise in defense of the poor…the downtrodden…the inebriated and the incompetent. Are the Fed’s efforts really futile, we ask? Are they worse than nothing? Well, the answer depends on who you are. If you have been holding euros, instead of dollars, you might want to send the Fed a ‘thank you’ note. The euro has been going up steadily, ever since Ben Bernanke began fighting recession with more cash and credit. Yesterday, it took $1.52 to buy a euro. Eight years ago, you could have bought one for only 88 cents.

Gold holders, too, should be happy with the Fed’s anti-recession program. Yesterday, the yellow metal dropped $17. But it has already added a third more value since the first rate cut last September.

And what of all the wheat farmers…and rice planters? Rice just hit a 20-year high. And the wheat growers are all buying shiny new tractors. Surely, they should be grateful. Of course, there’s the oil industry, too. Oil didn’t get to $100 a barrel on its own; it had the Fed behind it every step of the way. And don’t forget the platinum miners. Platinum has gone up 46% since the beginning of this year.

Last, but not least, there are the bankers themselves.

Among the Fed’s efforts to relieve the bankers’ pain has been a new line of credit – the Term Auction Facility. What a handy tool! It allows the banks to borrow against the same infected collateral that caused them problems in the first place. Private lenders wouldn’t touch it; but the Fed…as chump of last resort, with the taxpayers’ credit card in hand …accepts it as if it were lost Rembrandts and uncirculated gold coins.

We weren’t born yesterday. We know bakers don’t bake us bread merely because they want to see our fat, rosy cheeks. And we know bankers don’t bank merely because they want to see us with money in our pockets. So, we take it for granted that the bankers look out for Numero Uno just like everyone else.

Which is why we’re also suspicious of the latest initiatives to save homes from foreclosures. Ben Bernanke himself urged "banks to forgive portion[s] of mortgages," says a Bloomberg report. And there is another strange beast afoot…a proposed act of Congress, whereby the government would step in and buy the distressed mortgages itself. However much these measures might benefit humanity, we’re sure that the final wording would have them tossing a small bone to the bankers too.

*** "Price of wheat is soaring. So buying a loaf of bread is going to cost a lot more dough. What is happening?" our intrepid correspondent, Byron King wonders.

"Sure, we have lots of hungry mouths in this world. And more and more dollars are chasing those bushels of wheat, to feed those mouths. And couple it with the worldwide episodes of drought, and cropland destruction, and decline in soil fertility, and rising costs for seed and fertilizer and equipment. So just for reasons of limits on factors of production, it is harder and harder to increase supplies to match the growth in demand.

"But look at what else is helping drive the price of wheat upwards: Export tariffs.

"Whoops. The traditional use for tariffs was to limit imports into a nation, and protect domestic markets against ‘cheaper’ foreign competition. The idea was to protect domestic industry, and permit it to grow over time in a sheltered domestic market.

"But now the use of tariffs is shifting to control exports. The intent of these export tariffs is to protect internal national supplies of a critical commodity.

"But export tariffs are a two-edge sword. Tariffs may limit exports, of course. Export tariffs will limit sales into international markets. In doing so, they will support higher world market prices, because of limits to supplies in trade. And back home, export tariffs deny the benefits of higher world process to the domestic producers. That is, the farmer receives a ‘lower’ price signal. The taxing government is capturing the difference between internal and international prices, via the tariff. So there is less of a market incentive for the farmer to increase output, if that is otherwise possible.

"It gets back to the classical economic argument that tariffs distort markets. In the case of export tariffs on food, they limit production at home while supporting artificially high prices on international markets.

"Long term, tariffs are probably self-defeating. But that’s another discussion."

For more from Byron, check out his latest report. In it, he details a little known source of energy that he calls "China Lake Energy" that has enough reserves to significantly reduce our dependence on foreign oil. He’ll tell you what five penny stock companies — whose stocks are all priced less than $3 per share — that are set to take this energy public in a very aggressive and profitable way.

*** "This is war," said Damien yesterday.

Yesterday, we heard the shooting. Like the muffled sounds of handguns fired in liquor stores, it went on all morning. We thought for a moment that we were back in Baltimore.

Pow…pow…pow…at intervals of an hour or more each time.

"How’s the campaign going?" we asked at lunchtime.

Damien stood at the door of the library, with a large smile on his face. He wore his green overalls. And since the weather was so bad, he had on his cap with the large earflaps hanging down. The overall effect was of a big, friendly dog waiting for a pat on the head.

But this puppy was packing heat. Damien held in his hand a loaded, skeletal gun that looked like it may have been made in a prison shop, out of a license plate, when the guards weren’t looking.

"Not bad. You heard the shots. Each shot; one more dead mole.

"I think I’ve got them all from the front yard. Now, I’m going to attack on the left flank."

We wondered about his strategy and his artillery.

"Won’t they just come back into the front yard?"

"Yes, but not for awhile. This war never ends. It’s like your war on terror. You can never get rid of the moles entirely, because you can’t kill them all. But if you kill enough of them in the early spring, you’ll be fairly free of them all summer."

Damien’s war to exterminate the world’s moles goes back years.

"I’ve tried everything. Poison …traps…and just shooting them. Sometimes, I just take my rifle and wait. When I see a pile of dirt welling up, I just go over and shoot right down into it. Not very sporting. That stops them. But this is the best thing….

"This is an anti-mole gun," he explained, showing off the latest military hardware – an AMD, anti-mole device, as it is likely known in the trade. "You just put the cartridge in like this…and then you cock the trigger…like this…and then you put it in the mole hole. As soon as the mole touches it, he gets it right in the face."

"Oh…poor thing…"

"Nah…there’s no bullet. It’s just a charge of gas. Very humane."

"Oh…"

Until tomorrow,

Bill Bonner
The Daily Reckoning

Failed Experiments in Fiscal Stimuli originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."

The war between the Fed pumping money into the system and cutting the Fed fund rate to 2%, as David Rosenberg thinks, and the private sector withdrawing liquidity through huge write-offs in the financial sector, leading to shrinking balance sheets, will lead to increased volatility. Ten per cent market moves will be the order of the day. As was the case in the 1970s, we can expect the stock market to sell off by more than 20%. (Between 1968 and 1982, the stock market (S&P 500) had three major declines: 1968-1970: down 36%; 1973-1974: down 48%; 1980-1982: down 27%; and two minor declines: 1976-1978: down 19%; 1980: down 17%. At the time, the two adversaries facing each other were "easy monetary policies by the Fed" and "consumer price inflation".

Nobody won that war decisively, since stocks in 1982 were at about the same level they had been in 1964. However, since US equities had declined in real terms by 70% from their real 1966 peak to their real August low, one can assume that the Fed clearly lost that war.) Today, the adversaries are the private sector, which with its inflated asset values now wants to deflate, and the Fed, which under the present and last chairmen, never quite understood that larger and larger injections of liquidity into the system, leading to excessive debt growth, brings about a gross misallocation of capital.

I have no doubt that this war also will be lost by the Fed – if not in nominal terms, then in real terms, or adjusted for the sinking value of the US dollar. More to the point, this war has already been lost by the Fed: US equities fully recovered after October 2002 and made an all-time high in October 2007 in dollar terms, but even at their recent highs they were down by 37% in Euro terms (measured by the S&P 500) and by 60% in gold terms.

Still, we have to be mindful that even if the present economic and financial environment doesn’t look particularly enticing, as was the case between 1964 and 1982 when the market didn’t make any headway, plenty of investment opportunities will present themselves from time to time for the nimble trader and for the long-term investor who will be positioned in the few asset classes that will perform well. Moreover, it would be wrong simply to assume that recession and slumping corporate profit will inevitably knock down equity prices. Other factors such as negative real deposit rates and negative real yields on Treasury bonds because of the Fed driving down the Fed fund rate, a weak dollar, and "bubbly" emerging markets could make US equities a relatively attractive proposition compared to other financial assets.

Following this report, my friend George Karahalios – a very smart businessman who also happens to think and write clearly and has written for this report in the past – will make another strong case for precious metals and, in particular, for silver based on the gold-to-silver ratio declining further (meaning that silver will outperform gold). I am less certain about this occurring than he is, but that is irrelevant. What is relevant, however, is that – with Bernanke at the Fed and Paulson at the Treasury, and a Euro that could face some problems (a break-up, some believe) because of badly deteriorating economic conditions in Italy, Spain, Portugal, and Greece – precious metals are likely to outperform financial assets for some years to come. As Michael Berry remarked, "Gold is no friend to the world’s central bankers. The printing press is their friend." In fact, I would be very surprised if the Dow Jones Industrials/Gold Ratio didn’t decline to between 5 and 10 within the next three years at the outside. Therefore, I should like to reiterate my recommendation to accumulate gold. Both George and I agree, however, on one point: the precious metals bubble will be the last to burst.

Other commodities that could come to life in 2008 are sugar, cotton, natural gas, and palladium. Moreover, as Robert Mitchell (rmitchell@aditfunds.com) suggests at the very end of this report, uranium is unlikely to disappoint the longs. (Robert recommended in this report the purchase of uranium back in 2005.) Uranium Participation Corporation, listed in Canada (U CN), tracks the price of uranium. In general, some special situations aside, I am not positive for industrial commodities in a slow growth or recession type of environment.

Among commodities and currencies, my preferred asset remains physical gold held outside the US, for the simple reason that – depression or inflation – it is very likely to outperform financial assets. For gold, I believe the best is yet to come!

In terms of equities, I remain very cautious. It is difficult to find compelling values. Singapore REITs have declined by between 20% and 30% from their summer peak and, yielding around 5% to 6%, would seem to offer relative good value (given the soundness of the Singapore economy and its currency).

I still like the agricultural sector. Investors should consider buying the Dow Jones – AIG Agricultural Total Return Sub Index ETF (JJA). Japanese equities are out of favour and so, as a contrarian play for 2008, are among my top picks.

On the short side, I am inclined to think that most emerging markets have already topped out or will do so in the next six months or so. Given my less than optimistic take on the economy, I would also avoid all economically sensitive stocks irrespective of whether it is an economically hypersensitive stock market such as Korea, or retailers, basic and cyclical stocks such as steel, paper, engineering construction, and even energy and energy-related – at least for now. I would also avoid technology shares, since their two largest customers – consumers and the financial sector – are likely to perform poorly.

The current stock market decline will only end once the stocks that form the last bastion of strength succumb to heavy selling. For all short positions, stop loss orders are recommended and, as with longs, each individual is responsible for his or her own decisions based on his or her financial condition. It is physically not possible for me to be a financial planner for all my readers.

Aside from Japanese equities, a contrarian play would be to buy the US dollar. Perhaps we could still see a final dollar sell-off, but sentiment and headlines are so universally negative that at least a short-term rally should get underway shortly. The only problem I have with being positive about the dollar is that, whereas people are universally bearish about the dollar, they are also universally still long a gargantuan quantity of dollars! Still, starting January, seasonal strength should begin to be dollar supportive.

Have a happy New Year,

Marc Faber
for The Daily Reckoning
December 20, 2007

We are piling up those frequent flier miles!

Last night, we were checking in for the flight to Buenos Aires. The woman at the counter looked on her screen.

"Mr. Bonner…would you like to upgrade your ticket? You’ve got a lot of frequent flier miles."

For $100 and 25,000 miles we moved up to first class.

It’s a long haul down to South America. The $100 was well spent. We were able to go to sleep…and stay asleep for almost the entire flight. We only woke up in order to pull out our laptop computer so we could write to our dear, dear readers.

But what is there to say? A dull day on Wall Street? Everything has already been said?

Ah, there is always something to say.

"If your daily life seems poor," said Rilke, "do not blame it; blame yourself, tell yourself that you are not poet enough to call forth its riches."

Yesterday, the markets were quiet. Gold is holding over $800. Oil is holding over $90. And the Dow is still refusing to crack. Of course, it depends on how you keep score. We announced our Trade of the Decade in 2000 or 2001; we can’t remember. "Sell the Dow; buy gold" was our simple advice. The ratio of Dow to gold actually hit a high in August ‘99 – at about 44 ounces of gold to the Dow. Now, in terms of gold, the Dow has been more than cut in half. You can get the whole thing for only about 18 ounces of gold. The decade has another three years to run. We’ll stick with the trade, just to see what happens. The Dow has already run down in terms of gold. Our guess is that it will run down in terms of dollars too – probably in terms of nominal dollars and certainly in terms of real (inflation-adjusted) dollars.

Commodities reached a new high yesterday – another solid hit from the fist of inflation.

Inflation reeled, and then delivered a jab – foreclosures rose 68% in November…and then another jab – home construction is at the lowest level in 16 years. As a share of the GDP, residential construction has reverted to the mean – it’s back to where it was before the great property bubble began in 2001.

David Rosenberg of Merrill (NYSE:MER) connects home building to home ownership to consumer spending. In the bubble period, builders put up houses, sold them to people who had never owned homes before – homeownership went from 65% to 70% – and then the new homeowners started spending. They were able to spend more than ever before because for the first time in their lives they had an asset that was rising in price. Consumer spending went up with home ownership – from 65% of GDP to over 70%.

But now, homeownership rates are falling again. They’re reverting to the mean – which is about 65%. And consumer spending seems to be following, reverting to the mean too.

Rosenberg thinks this process of reverting to the mean in homeownership and consumer spending will be so painful, the Fed will drop rates back to 2% to try to combat it.

We think he is right.

But let’s keep moving…let us draw forth some richness elsewhere. Let us look at the big picture. Ah, here is where it gets very, very interesting.

The Reagan/Thatcher revolutions brought subtle changes to the English-speaking world. People said that these victories were triumphs for conservatism and for laissez-faire capitalism. But they missed the point completely. The Reagan/Thatcher revolutions brought new ideas that had little to do with conservatism or free market principles. What they really brought was a form of enlightened socialism…a way of harnessing market forces for the benefit of the state and the elites who control it.

That was the genius of Arthur Laffer’s celebrated curve. You could lower tax rates, he said…not because people should be allowed to spend their own money…but because it would actually increase tax revenues to the government! Likewise, reducing regulation in some areas would increase economic activity, increase GDP, increase tax receipts and result in more money and power for the politicians.

Clever. Very clever. And what difference did it make if their motives were not exactly those of true conservatives? They were headed in the right direct; that was enough. But now it is a quarter of a century later. Now, we are just beginning to realize what has been wrought: The horrors. The horrors still to come. (Interestingly, we are interviewing Dr. Laffer today, for our upcoming documentary, I.O.U.S.A., which premiers at the Sundance Film Festival next month. We’ll let you know how it goes…)

The old conservatives would have been happy to see taxes cut. As we old, fuddy duddies here at The Daily Reckoning put it: we’ve never met a tax cut we didn’t like. But the old conservatives insisted on cutting spending too. "Balance the budget" was an old-time conservative gospel lesson. The new conservatives ignored it completely. "Deficits don’t matter," they said. As it turned out, they had another agenda. And that agenda required money…lots of money.

Then, when Mr. Alan Greenspan was brought in to manage the Fed, it looked to many people as though the government was going further in the direction of laissez-faire economics. Not so again. Soon the entire world financial system was set to work in a perverse new way…

If any readers think they know where we are going with this…please contact us immediately…we’d like to know!

*** Murray Rothbard had Alan Greenspan’s number a long time ago. (Many thanks to our old friend Marc Faber for bringing this gem to our attention.)

"I knew Alan thirty years ago," Rothbard wrote in 1987, when Greenspan was first appointed to head the Fed. "and have followed his career with great interest since…Greenspan’s real qualification is that he can be trusted never to rock the establishment’s boat…at no time in his twenty-year career in politics has he ever advocated anything that even remotely smacks of laissez-faire, or even any approach toward it… Alan is a long-time member of the famed Trilateral Commission, the Rockefeller-dominated pinnacle of the financial-political power elite in this country. And as he assumes his post as head of the Fed, he leaves his honored place on the board of directors of J.P. Morgan & Co. and Morgan Guaranty Trust."

It was pointed out that Greenspan had been a devotee of Ayn Rand, who had the quirky presence of mind to die on Alan’s birthday. But Randism is not laissez-faire-ism. Randism is looking-out-for-number-one-ism…a creed Alan Greenspan never forgot.

We are annoyed at Alan Greenspan, not because he set the U.S. middle class on the path to destruction but because his book, The Age of Turbulence, got so much more attention than the book we wrote with Lila Rajiva, Mobs, Messiahs, and Markets. Mr. Greenspan’s empty tome came out right after ours…and promptly knocked ours out of its brief moment in the limelight.

But now others are getting annoyed at Mr. Greenspan too – for more serious reasons. Says Nobel Prize winning economist Joseph Stiglitz:

"Alan Greenspan really made a mess of all this. He pushed out too much liquidity at the wrong time. He supported the tax cut in 2001, which is the beginning of these problems [deficits didn't matter to him, either]…He encouraged people tot take out variable rate mortgages."

The critique we leveled against the Greenspan Fed three years ago is now widely accepted; the feds saw the little recession of ‘01…and panicked. They put out too much money and too much credit for much too long, causing bubbles all over the world. So free and easy were American banks and credit institutions during this period that bank robbers stopped wearing ski masks and carrying guns; all they had to do was to ask for the money like everyone else.

The free-floating loot produced a holiday atmosphere that looked to most people like real prosperity. "See," they said to each other, "the free market works."

"Greed is good," said Gordon Gekko. Financial incentives were thought to be the key to everything – higher productivity, higher profits, growth…everything. You want an executive to perform? Give him stock options! You want an investment manager to make you money? Give him a piece of the action. You want to win over the poor and minorities? Let them get in on this great money making machine. Remember all those columns by Thomas L. Friedman that we made fun of? Friedman keeps telling us that the terrorists would come over to our side if they just had more financial incentives…if they had jobs…if they had university degrees…if they had credit cards and mortgages. But it emerged in England that of the terrorist suspects nabbed so far, the average one was a doctor working for the National Health Service!

Money isn’t everything. Especially the kind of money that the Fed creates.

More to come…

*** "Florida doesn’t tax income," explained a friend yesterday. "But they hit you hard on property taxes. I pay close to 2% of market value. And market values have gone way, way up. So, even though I don’t have a mortgage, I end up paying the equivalent of a mortgage on a reasonably-priced house. See what I mean? My house has doubled in price in the last five years…actually much more than that, but let’s keep it simple. So if I pay 2% on the value of my house today, it’s the same as 4% on what the house is really worth. I’m protected a bit because I’ve owned this for a long time…and it takes them a while to catch up to the market. But imagine some fellow who bought recently. He paid top dollar…and he’s got the property taxes to pay too. And, of course, that’s just the beginning. If I want to ensure against hurricane damage…that’s thousands more. And then there’s regular maintenance, utilities…etc. etc. Home ownership is a big pain in the neck."

"I’ll tell you what’s going to happen. People are going to turn away from big, expensive houses. I feel it happening. It’s part of a change in sentiment. The baby boomers who’ve been buying these things are running out of money and credit. They’re going to be forced to cut back. And I remember you wrote once something that stuck in my mind – ‘people come to think what they have to think when they have to think it’ – or something like that. That’s what I expect. People without money are going to come to think that not having money is cool. They’re going to downsize. And they’re going to think that people who drive big, expensive cars…or live in big, expensive houses are uncool. Already, when I drive around in my 12-cylinder BMW I feel my neighbors laughing at me. It was cool a couple of years ago to have a car like that. Now, it’s uncool. Everybody thinks you’re out-of-style; it’s as if you had a mullet…or a polyester leisure suit, but those are probably coming back in style. And they think you’re destroying the environment too."

Until tomorrow,

Bill Bonner
The Daily Reckoning

The Fed’s War originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."

Will rate cuts be of much help to the asset markets and the economy? I believe we are in a war between two major adversaries. On the one side we have the Fed (and other central banks) pumping liquidity into the system in a desperate attempt to support the asset markets and the economy. On the other side we have the private sector, which, as Hatzius explained, is being forced to curtail lending due to heavy losses in the credit market and to fight the Fed’s reflation efforts by widening credit spreads. Complicating matters is the fact that both adversaries have powerful allies.

The Fed has the Treasury and the government, as well as the Wall Street elite, as allies. The government could implement massive tax cuts in order to stimulate economic activity; the Treasury could bail out financial institutions, which in reality should be punished by bankruptcy; and the monied Wall Street elite will ensure that politicians and the Fed make it possible for them to continue their con-game. The private sector has allies in the form of inflation, a weak dollar, and a dissatisfied public (declining consumer confidence and lack of trust in government, which is reflected by the strong showing of Ron Paul), all of which form a powerful phalanx when battling the Fed’s reflation attacks. Inflation is a powerful ally for the private sector because it squeezes corporate profits and curbs personal consumption.

According to David Rosenberg, with 90% of companies reporting, third quarter operating EPS fell 8.5% year-on-year; while reported earnings, which include charge-offs, fell 28% year-on-year! Rosenberg also notes that "at $15.29 reported EPS for the S&P 500 in the third quarter of 2007, the P/E multiple on this basis is a lofty 23x – not the 18x ‘cheap’ multiple (or 14x on forward estimates) that is constantly being bandied about in the media." He adds dryly: "[T]he current $15.29 estimate for reported EPS is the lowest level of earnings since the fourth quarter of 2004. And where was the S&P 500 trading at that time? Answer: It averaged about 1,162 that quarter – just in case you were thinking of buying this dip." (I can’t wait to hear the Goldilocks’ crowd’s positive spin on these dismal earnings.)

The war between the Fed and the private sector will, in my opinion, be very protracted. The Fed will win some battles, which – along with much brouhaha in the media – will see Pyrrhic victories such as the stock market rally of August to early October, which led in dollar terms to new highs but failed to do so in Euro and gold terms, and was followed in Euro terms by renewed severe weakness. (Just for the record, as of this writing, the S&P 500 is down 9% year-to-date in Euro terms, having peaked out in June.)

Other battles will be won by the private sector, which through its contraction (recession) amidst inflation will lead to sharp downward movements in equity prices.

I am well aware that the Bureau of Labor Statistics and the Bureau of Economic Analysis will continue to use bogus figures when reporting inflation, and hence real GDP growth, but they won’t be able to hide the squeeze on corporate profits and the consumer from rising prices. I am writing this report at Thanksgiving, an opportune time to point out that the American Farm Bureau Federation has calculated that the cost to feed ten people dinner in 2007 is US$42.26, up 10.9% from last year and the biggest year-on-year increase in over ten years (David Rosenberg has compiled a Thanksgiving cost-of-giving index, which amalgamates the prices of turkey, sweet potatoes, cranberries and gifts, as well as travel expenses: it rose this year by 7.9%.) I don’t suppose these indexes took into account the rise in heating and electricity costs for the festivities, or the cost of a nice Bordeaux wine and bottle of Cognac, due to the weakness of the dollar. (I might add that in Switzerland it wouldn’t be possible for ten people to be served Christmas dinner for that amount.)

But the point is simply this: cost-of-living increases vastly exceed the reported inflation figures and are squeezing the consumer, which leads to revenue pressure for the corporate sector. (According to the Kaiser Family Foundation, health insurance premiums have risen 78% since 2001, while wages have gained only 19% and "the government’s inflation measure during that stretch was 17%".) At the same time, corporations are faced with a squeeze on margins due to rising costs.

Pressure on revenues and cost increases contributed to the dismal performance of earnings in the third quarter of 2007. For example, Starbucks (SBUX) increased prices by an average of 9 cents a cup in July. However, customer visits to US stores fell 1% for the quarter ended September 30. Starbucks’ CFO noted that a "similar decline may occur in the fourth quarter although they will be positive for the full year". (This would seem to indicate that the economy slowed down considerably in the second half.) According to him, "unbeknownst to us, we saw economic headwinds that quite frankly came up probably stronger than I thought." Earlier, Starbucks’ CEO had remarked: "The consumer is being faced with rising costs in every sector of their lives, and so part of that is reflecting on us." An informed friend of ours suggested that declining traffic at Starbucks stores in the US is of particular concern, since Starbucks serves all income levels.

Therefore, declining traffic is not just a "sub-prime problem"! I should now like to reiterate what I have explained on a number of previous occasions. Rather than paying too much attention to the media and to analysts’ positive spins, it will pay to watch the market action of equities as a forecaster of business prospects. Starbucks’ stock made a double top between May 2005 and November 2006. After that its shares went downhill, although the stock market continued to rise to its final peak in mid-October 2007. This should have been a warning sign that Starbucks fundamentals were deteriorating.

Similarly, the fact that retail stocks failed to better the July high in the recent August 16 to October 11 rally, which led to a new all-time high for the S&P 500 in dollar terms (but not, as we have shown, in Euro terms), isn’t a good omen for retail sales, consumption, and the economy. I am not the only person who questions the economic statistics published by the US government: writing recently for Kate Welling (welling.weedenco.com), Lee Quaintance and Paul Brodsky of QB Partners observed:

"…the credit markets finally clogged towards the end of Q2 2007, closing the major private sector artery policymakers had been using to synthesize domestic output (expressed in nominal dollar terms through nominal GDP growth). True to form, they began creating U.S. dollars out of thin air at an accelerated rate in Q3 2007 (14.7% annualized). The Bureau of Economic Analysis (BEA) published nominal U.S. GDP growth at an annualized rate of 4.7% in Q3 2007. Taking the BEA’s figure at face value and subtracting the annualized rate of monetary inflation, we believe inflation-adjusted U.S. GDP contracted at about a 10% annual rate in Q3 2007. This rate of economic contraction would seem to be consistent with the analysis of the corporate profit slump discussed above, and with the observations made in earlier reports that the US economy is already in recession.

Regards,

Marc Faber
for The Daily Reckoning
December 19, 2007

P.S. You can read the conclusion to this essay in tomorrow’s issue. Be sure to tune in…

No big news from the markets yesterday. Inflation and deflation fought to a draw…and then called it a day.

The Dow fell 65 points – and we noticed that copper was down about 25% from its high. Copper, as you no-doubt know, dear reader, is regarded as the metal with a Ph.D. in economics. When it goes down, the economy tends to go down with it.

You don’t have to be a genius to figure out why. Copper is used in making machines and houses. When demand for copper goes down, so does business activity.

After landing those blows, deflation followed up with a nice combination of jabs. Building permits were reported at a 14-year low. And in Southern California, house sales sank to a 20-year low.

Wiring new houses takes a lot of copper; so when there are fewer new houses, there is also less demand for copper. And less demand for financing – which is a good thing, since financing is less available anyway. Financial stocks have already lost $74 billion of value this year. Moody’s is down 50%. Merrill (NYSE:MER) is down almost 50%. KKR Financial has dropped from 27 down to 14.

And when housing and finance go down…it shouldn’t be long before the entire economy follows.

"The bottom line," writes David Rosenberg of Merrill, "is that housing and consumer spending were joined at the hip…and now that hip is going in for replacement."

Consumers can’t make money from rising house prices. And they can’t borrow money either. All they can do is to spend the money they earn. Ouch. Ouch. And in an economy that relies on consumer spending for 70% of its GDP, a falloff in consumer spending is very bad news.

Yes, dear reader…a recession is probably on the way. Maybe it is here already. And it will probably be a real recession this time, not just a phony recession such as we had in 2001. This time the consumer will actually have to cut back on his spending. This time, consumer credit will actually go down. In short, this will be a recession worth having.

When the dotcoms went down, it affected no more than about 10% of the economy – at the most. When residential housing goes down, the damage will be much more widespread, long-lasting and deeper.

Even the art market is beginning to get hammered. A report in the International Herald Tribune tells us that while prices have held fairly steady, it has come at a large cost in sales. At Christie’s, for example, 19% of the stuff for sale at a recent auction "hit the dust," meaning – it didn’t sell. At Sotheby’s the total rose to 27%; lots at a recent auction didn’t make the minimum prices set by sellers. In other words, prices weren’t allowed to get to a market-clearing level. Result: no sales. And no information. We don’t know how low prices would have gone if they had been allowed to fully express themselves.

Turns out, the auction houses are giving sellers ‘guarantees’ that effectively stop the market-clearing process. If the price drops below the guarantee, the object is simply removed from the sale. In art, as in houses, it will take a long time to discover where what things are really worth.

But if we were a judge, we’d still have to give the day to inflation – on points. For while copper is getting knocked down, platinum never looked stronger. It’s at a record high and punching hard.

A headliner item on the inflation side was the price of wheat, which also rose to an all-time high.

"Grocery bills keep growing," says an article in the Dallas Morning News. And the U.N. goes further, with a report saying that not only are prices rising – the world’s food supply is shrinking.

Shrinking? How could the world’s food supply be going down when the world’s population is growing so rapidly? How could farmers produce less food when they have so much more technology to work with? How could food production decline when so many marginal properties are being put into production? We don’t know. But if it is true that farm output has peaked out, prices of agricultural commodities should rise even more steeply in the years ahead.

Meanwhile, the American Farm Bureau tells us that it costs more than 10% more to feed people this year than it did a year ago – up to $42.26 for a group of ten. Not in Switzerland, says our old friend Marc Faber. Only in America could you feed 10 people on so little money. But the key point is that prices are rising sharply. Remember, inflation packs a wallop – especially among the marginal middle and lower classes, where food is a large percentage of the family budget.

Then again, as they have to pay more for food and fuel…they will have less left over. Which, of course, means less consumer spending…recession…falling demand…and…what?…falling prices! Go figure…

We don’t have time to figure…we’ve got to run and catch another plane…

Ta-ta…

*** We’re in the air again…this time down to sunny Florida.

As long term Daily Reckoning sufferers might recall, we were moving to Florida in order to save taxes. Well, we weren’t really moving to Florida. We do not live in the United States at all. But if we weren’t going to live in the United States it seemed like an extravagance to not live in a high-tax state like Maryland. We’ve been paying taxes to the state of Maryland for the last 12 years – all the while barely setting foot in the Old Line State.

Along came a tax attorney with some good advice: move. Specifically, move to Florida; the Sunshine State doesn’t have an income tax.

So here we are, setting up non-residence.

"Wait a minute," said an attorney yesterday. "Why do you need to be a resident of any state…since you don’t really live in the United States?"

It was a good question. Too bad we didn’t have a good answer. Because it now looks as though we’ve been paying taxes for nothing. Of course, all taxpayers pay taxes for nothing…or next to nothing. But we didn’t have to pay Maryland after all. We’re going to ask for our money back.

*** Where would you rather live, dear reader, Paris, France, or Paris, Texas?

In Paris, France, you have art, culture, food, architecture, theatre, films, restaurants, cafés, bistros and museums. But Paris, Texas, has its charms too.

Actually, we can’t think of any. But in Paris, France, you will pay $1 million or so for a 1,400 sq. ft. apartment with nothing in it. In Paris, Texas, on the other hand, for only $84,000 you can buy a 3-bedroom house, 1,352 sq. ft., with a laundry room, garage and patio.

We saw a photo of it in today’s USA Today. Ugly as sin. Still, what do you expect for $84,000?

More to come…on the humbug of modern American win-win capitalism…on vernacular architecture…on the Wow Factor…and more!

Until then,

Bill Bonner
The Daily Reckoning

Will the Vicious Credit Virus Affect the Real Economy? originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."