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The Daily Reckoning Friday, August 21, 2009 Try as you may, you'll never escape all the risks... The 'world's mouth' has gone on a diet... If investors drop the dollar, what do they take up in its place? Bill Bonner on why there won't be a recovery...not now, not ever...   The World Financial System's Achilles' Heel by Bill Bonner Ouzilly, France The dollar fell to $1.42 per euro yesterday. Many believe it is the Achilles' heel of the entire world financial system - and Warren Buffett is among them. The story goes, Achilles was dipped in the river Styx and made invulnerable. But his mother held him by his heel, leaving that part untouched by the magic waters. Naturally, that is where a poison arrow got him. The moral of this story is that you have to go all the way. If you want your baby to be invulnerable, put him all the way under the water...even the heels. Or, maybe there's another point: that there's always some place where you're vulnerable. For the purpose of today's tale, we'll take the second possibility. Try as you may, you can never escape all risks. All over the world, consumer prices are falling. The world has too much capacity...too many factories...and too many workers. Too many, that is, for current demand. The 'world's mouth' - the USA - has gone on a diet. And if the United States reduces its intake, that means the rest of the world - especially China - must reduce its output. Otherwise, the whole thing will become unbalanced. Yesterday's news tells us that despite press reports of a recovery, the key indicators of real economic growth are still falling. Almost one out of ten mortgages are now delinquent. And the rate of foreclosures is increasing faster than any time in the last 30 years. Housing prices, meanwhile, fell 16% in the 2nd quarter, from a year earlier, according to the National Association of Realtors. Unemployment claims went up last week. The sharp eyes of The Financial Times see the link: "Mounting joblessness fuels US housing crisis," says its headline. In the real economy, people are cutting back...with the inevitable results we discuss every day here in The Daily Reckoning. One major consequence of reduced demand is too much supply. The factories built in China to supply products to America during the bubble years now find they have no market. Currently, overcapacity and oversupply are causing prices to fall. Falling prices mean rising currency values. Each unit of 'money' buys more stuff. But there are many competing currencies, and they don't all rise and fall together. Even in a world of deflation, some currencies will deflate more than others. The dollar is, of course, the world's main money. In a sense, the whole world economy is under its heel. But it is a heel that has never been dipped in the river Styx. It is now a heel that waits for an arrow. PIMCO is the biggest manager of bond funds in the world. It says the greenback is going to lose its status and lose its value. "Investors should consider whether it makes sense to take advantage of any periods of US dollar strength to diversify their currency exposure," says its Emerging Markets Watch report. "The massive amounts of US dollar liquidity produced in response to the crisis" doom the currency. Both China and Russia are calling for a new global currency to replace the dollar. "While we have not yet reached the point where a new global reserve currency will arise, we are clearly seeing a loss of status for the US dollar as a store of value even in the absence of a single viable alternative," continues the PIMCO report. Meanwhile, our old friend Jim Rogers says he is moving all his assets out of dollars and buying Chinese yuan. And Warren Buffett warned this week - writing in The New York Times - that "greenback emissions" threaten the whole world econo-system. But what does it mean? What are the threats to you? What are the opportunities? If you pay your bills and keep score in dollars, what does it matter if the dollar loses value against the yuan? If prices are generally falling, the dollar is actually getting stronger, isn't it? So what if some other currencies are getting even stronger still? Colleague Bill Jenkins, at Master FX Options Trader puts in his two cents: "We lived through a financial earthquake in 2008. The effects of it are still being felt. Aftershocks may still be ahead. But predicting when they'll strike is just as hard as predicting natural earthquakes. We had a number of prognosticators for years telling us about what would happen last year; it's just that they didn't know when. And that is the hard part of the life of a prophet. "And while it is equally difficult to tell when the next economic tremors will hit, we can look at the numbers and make some predictions as to their cataclysmic effect." Bill goes on to say that he thinks the US is headed for another shockwave...which will include another round of dollar buying - even while the 'experts' are touting 'green shoots' and a return to normalization. [While Bill Jenkins doesn't see rosier days in the cards, he does see more opportunity to play the global turmoil, using some choice foreign currencies. Learn about his recession-proof gains by clicking here.] More...after the news: "After a remarkable 51% rise, the S&P 500 has spent most of August wondering what to do next," writes Ian Mathias in today's issue of The 5 Min. Forecast. "There have been some sell-offs and rebounds, but essentially, stocks have taken the month off. See for yourself: "Since forecastin' is our business, let's tackle the mother of all barstool queries: Where's the market heading? "'Consider the sentiment toward overall market,' Dan Amoss suggests. 'Aside from the investor sentiment polls, you can tell how bullish investors are by the multiples they are willing to pay for stocks. And right now, after the sharpest 5-month rally since the 1930s, the market is trading at valuations that require a strong economic recovery, and a return to credit bubble conditions. The rally was powered entirely by P/E multiple expansion, not earnings growth. That sort of rally would be justifiable if corporate revenues and earnings were about to soar, but they're not. Most earnings surprises were due to cost cutting, rather than top-line growth, which is like burning your furniture to stay warm. "'The market is not even that cheap when you consider how artificially inflated earnings were at the 2007 peak. Financial earnings made up 18% of the S&P 500's earnings in 2007 - much more if you add the 'earnings' from the finance divisions of industrial conglomerates like GE and GM. Any claims that the S&P 500 is cheap because 2007 somehow represents 'normalized earnings power' are bogus. The corporate profit margins and earnings won't return to that level for many years." On Monday, August 24th, at noon, Dan Amoss will expose the biggest banking lie of the past 64 years...and you could stand to triple your money. See his latest report for all the details...and find out how you can get a month-long trial subscription to Strategic Short Report research service for just $1. And now, back to the dollar: The trouble with the Achilles' heel is that it is connected to the Achilles' tendon...which is connected to the leg muscles...which is what keeps the whole thing moving forward. Cut the tendons and the feet go flippety, floppety and you get nowhere. Yesterday came word that the US deficit for 2009 might come in lower than expected. Instead of borrowing $1.8 trillion as anticipated, the feds might only borrow $1.58 trillion. Well, that still leaves them about $680 billion short - even if every dollar of trade deficit and every dollar of domestic savings is applied to it. But definitely a step in the right direction! This gap must be closed by quantitative easing, or, in other words, by printing press money. So, holders of old dollars are bound to wonder how much their savings will be weakened by the addition of so many new ones. They're likely to wonder, too, how much those US Treasury notes will be worth after this monetary inflation catches up to them. At some point, they are likely to think twice about buying more of them...and possibly even want to sell the ones they have already. Either way, it could create a nasty financial whirlpool that sucks down the entire world economy. As private investors reject US dollar credits, the Fed would be forced to print up more money to buy them itself. As the Fed buys more, private investors become more fearful that this monetary inflation will lead to consumer price inflation; they may panic and dump all dollar-denominated assets. But if investors drop the dollar, what do they take up in its place? Oil...maybe. Oil is selling for $72 a barrel, even while the world is in a major downturn. What makes it so expensive, if not the fear that the currency in which it is quoted is more slippery than the black goo itself? And gold? Yesterday, gold lost $3. But is still trading in the mid- $900s - not far from its all-time high. And this at a time when consumer price inflation is going down! In the US non-oil export prices are falling at a 5% rate. If people are buying gold as a hedge against inflation, they must know something we don't. Consumer prices are falling...actual CPI rates are negative in many countries already. Take out the effect of speculation on oil and commodities, and deflation is probably a fact of life almost everywhere. Gold buyers are not hedging against an increase in the price of bread, in other words; they're hedging against a poison arrow directed at the dollar itself. [Though gold may not make you rich tomorrow, as a long-term investment, there's nothing better. Strike while the iron is hot...or, while gold is relatively cheap. It's sure to get much higher than it is now...perhaps as high as $2000 an ounce. Learn how you can avoid the rush and pad your portfolio with the yellow metal now. See here.] It is a real Ouzilly summer. We feared we would be alone this summer. Our children almost all grown, we imagined ourselves sitting on the veranda and talking just to each other, like a pair of old shoes left in the closet. No family was coming from the United States to visit. Our daughters were pursuing their careers. Our sons had plans of their own. But then a Swiss friend came. And then his mother came. And then the boys showed up. And then an Irish journalist. And then an Italian egg producer. And then an Argentine singer. And then, a girl from across the street. And then a girl from the village. And then...the house was full... In the kitchen yesterday, three women busied themselves...making jam...polishing the old stove...sharing gossip and jokes. It was like a scene from an earlier era...when people had regular kitchen staff. Our 'staff' are all volunteers and part-timers. Still, the ambiance was rich and convivial. "Do you want a cup of coffee?" one asked. "Yes...but I'll make it...." "No...I'll make it...you shouldn't make it. You're the head of the house. You're the one who keeps the place going..." "Oh...yes...well...that's a nice way to look at it..." "Yes, without you, we'd have to go to the beach for the summer...and we wouldn't have the pleasure of working in this hot kitchen. I'm just joking. It's fun working in the kitchen. This is where the action is. Did you know that? It was always the kitchen that was the place to be in these big old houses. That was where the maids and gardeners and all the staff hung out...in front of the fire. It was often the only warm room in the house. Everyone wanted to be in the kitchen. And it was where the food was. "And people in the kitchen know what is going on... The maids come down and report on the state of the bedrooms...and who is sleeping with whom. Yes...that's the way it was...at least in France. And they hear who is arguing with whom...and about what. And the staff keep their eyes and ears open...and then they come into the kitchen and talk. There were never any secrets in a place like this...the people in the kitchen knew everything..." Keep reading for today's essay... The Daily Reckoning PRESENTS: The key to understanding the great credit bubble of 1945-2007 is to capture the codependent relationship between China and the United States of America...especially now that that relationship is at odds with one another. Bill Bonner explores, below... No Recovery, Not Now...Not Ever by Bill Bonner Ouzilly, France That we live in an age of miracles has become common knowledge. A man may sit on a beach near Sydney, with nothing but the bucket bottom of the universe over his head, and still carry on a casual conversation with an Eskimo near the North Pole. Using an Internet-based phone service, he may do so at negligible cost. If this were not miracle enough, he may now grow himself a new nose, if he needs one, on his own arm. In this age of miracles, people seem ready to believe that anything is possible. Recklessly crossing the street at the end of the Late Bubble Epoque, the world economy got hit by a cross-town bus. Now, the feds propose to reverse and run over the poor fellow again. It will be as if they had reversed the film; the economy will be as good as new, they say. But we are suspicious. And we begin today's rumination by examining the bus driver's motives. In its naked form, government is not evil; it is merely a self- interested parasite, like a bank lobbyist. Its main value comes from its ability to elbow out other parasites. Of course, the typical citizen is no saint either. Instead, he is merely a parasite in the larval stage. If he is lucky enough or cunning enough, he could grow into a parasite himself. The citizen, generally, doesn't mind being lied to and robbed - just so long it is by someone he elected. Or at least by someone whom tradition or local connivance put in place. He does not usually resent his homegrown government, even though it routinely costs him a substantial part of his output. On the contrary, he grows so fond of it he even dons his helmet from time to time to protect it. Naturally, the feds return the favor. The basic business model of government is to keep order, protect campaign contributors and lure supporters with the promise of other peoples' money. The game plan of the typical citizen is even simpler: to be on the receiving end, not the paying end. Over time, more and more of them get into position. And the whole society becomes more costly, and more corrupt. In the United States, entire industries now operate as wards of the state. They may have too little capital. Or, their operations may be too costly. Or, their products may be simply out-of-date and unattractive. Still, government keeps them going - even at the cost of at the expense of competitors. And the money doesn't only go to business. Cities stay solvent only by the grace of federal government grants. Whole sections of the population depend on government - including 34 million who draw their rations directly from the federal food stamp program. The spectacle is breathtaking and alarming at the same time - like a Pakistani bus on a mountain road, freighted with passengers clinging to the roof. The old rust bucket could tip over at any time, but what politician would tell a voter to get off? That preface on the state out of the way, we turn to the state of the economy. The key to understanding the great credit bubble of 1945-2007 is to capture the codependent relationship between China and the United States of America. It seemed to serve both parties well. Each enabled each other's excess. China added mightily to the world's supply - far more than was actually needed. America, meanwhile, did heroic work on the demand side. While the growth in the United States was led by consumer spending, the growth in China was led by capital investment; factories expanded, towns were built, and output was revved up. But there was a flaw. Americans ran out of money. After the '70s, they could only increase their buying by going into debt. This they did with insouciance bordering on insanity. Total debt rose 370% of GDP and then blew up in 2007, with major lenders forced into bankruptcy and mergers, while GDP sank at its fastest pace since the end of WWII. "Borrowing to consume is merely tricking stuff from the future to enjoy in the present... It would be better to invite the future in...let her collect her debts...and then get on with things. Yet government officials on both sides of the Pacific continue their numbskull efforts to revive the bubble economy." Now, the old formula no longer works - neither for Americans nor for the Chinese. Despite the urging of their government, Americans cannot be expected to take on more debt in order to consume more stuff from China. As savings rates grow toward 10%, demand from the United States will collapse by an estimated $1 trillion per year. With the China trade now accounting for 83% of America's non-oil trade deficit, you'd think the Chinese would panic. They already have as much as two times the output capacity needed to meet real demand. They should trim their manufacturing sector, not expand it. We draw out that relationship only to show how hopeless it would be to draw it out further. Borrowing to consume is merely tricking stuff from the future to enjoy in the present. By 2007, some $30 trillion worth of spending that would have occurred 'in the future' had already occurred in the past. Factories that would have produced consumer items for 2009 discovered that they had already produced more than enough of them in 2005 and 2006. It would be better to invite the future in...let her collect her debts...and then get on with things. Yet government officials on both sides of the Pacific continue their numbskull efforts to revive the bubble economy. On the US side, the feds are trying to stimulate demand for more stuff. On the far side, Chinese stimulation is going into producing more stuff. As if the world didn't have too much stuff already. But the role of government is neither prosperity nor plausibility...but protection of the pests and parasites. They will keep paying them off and carrying them along...until the bus runs off the road. But it's not prosperity that government really cares about. The big bus keeps trundling along - picking up pests and parasites along the way. It will keep going until it runs off the road. Enjoy your weekend, Bill Bonner The Daily Reckoning Editor's Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis. He is also the author of, along with Lila Rajiva, Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics. Bill's latest book, an update of Financial Reckoning Day, co-authored with Addison Wiggin, is now available for purchase by clicking here: Financial Reckoning Day Fallout: Surviving Todays Global Depression The Daily Reckoning - Special Reports: History of Financial Disasters: Will you be Wiped Out? US Recession: By far the Weakest Recovery Introducing the Single Best Way to Make Sure You'll Never Run Out of Money...