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The Daily Reckoning Tuesday, September 29, 2009 The war in the world financial system drags on... You don't win votes by denying voters what they want... A recovery of some kind in global trade... Puru Saxena tells us that inflation is our future...and more! The Battle of the World Financial System Drags On by Bill Bonner London, England The rally may end any day, but it didn't end yesterday. Stocks rose 127 points, as measured by the Dow. Oil closed at $66. Gold rose $2.50. We said we were doing some serious thinking this week. Maybe it is the season. But more and more, our thoughts become grayer. Less black. Less white. Less hard. Less soft. A few years ago, it looked to us as though the world financial system had gone to war. We cheerfully awaited the victory parade. We figured Mr. Market would whup the feds good and hard. It hasn't happened so far. On one side, are the forces of a natural market correction...following a long, long period of expansion. The easier money gets, the more people tend to misspend and mis-invest it. Then, inevitably, their mistakes must be corrected. That's what bear markets and recessions are for. But the feds don't like bear markets or recessions. And at least since the Keynes outlined his general theory back in the early 20th century, they've believed that they don't have to put up with them. Keynes took a page from the Old Testament. Government should act like an enlightened Egyptian Pharaoh, he didn't say, but should have. It should run surpluses in the fat years and deficits in the lean years...thus flattening out the pattern of boom and bust. Pharaoh was no dope. He stored up grain for seven years, when the harvests were bountiful. Then, when the seven lean years came, he released the grain to the people. Problem solved. Keynes believed that modern government could do the same thing. But Pharaoh was not running a democracy. He had no voters to answer to. So, if he wanted to store grain in the fat years, he could do so. In theory, the US government could do the same. But, in fact, it never runs significant surpluses. There are too many people who want too much bread and too many circuses. And you don't win votes by denying the voters what they want. So, in practice, the feds run deficits even in the fat years! Last year, before the downturn really started to bite, the US federal government ran the biggest deficit in history - nearly half a trillion dollars. Now, let's imagine how that would work for a bad Pharaoh. He would give out grain in the fat years. This would encourage farmers to produce less grain. Then, when the lean years came, Pharaoh would have no grain to give out...and the farmers would have less grain stored up themselves, since they grew less during the boom years. The famine would be worse than ever. Then, if we can imagine that Egypt was trading with China at the time, perhaps Pharaoh could borrow grain from the Zhou dynasty to help ease the peoples' pain. Perhaps he could mortgage the pyramids. Whatever, he - and the Egyptian people - would have been in much better position if he had done as Joseph told him in the first place...lay up stores in good times, draw then down in bad times. How difficult is that? But Bernanke didn't see the famine coming. Neither did Geithner. Or Greenspan. Or any of the other savants Pharaoh interpret his dreams. None of them expected hard times. None of them warned the public. None of them encouraged the government to save money for the recession. Nassim Taleb asks why Bernanke was reappointed after he clearly failed the most critical test. But heck...the federal government is an equal opportunity employer. Employees aren't let go just become they're incompetent. Anyway, getting back to our thoughts... ..it looked like a battle to us - between the forces of inflation (the feds)...and the forces of deflation (the market). But battles usually have clear winners. One side is master of the field and the other retreats. One side is victorious; the other is defeated. Alas, some wars produce no hosannas of success...and no wailing widows of failure. Some end in draws...or in confusion...or in disgrace and bankruptcy for both sides. Like the bad Pharaoh, the feds saved nothing. Now, they have to try to work their Keynesian magic on credit. This puts them in a weak position; like a government that wages war on borrowed money. They can continue their campaign only as long as lenders allow them. They can't wage the war as effectively as they'd like. Then again, maybe they can't lose it as spectacularly as they might. For the moment, their credit is still good. The bond market foresees an inflation rate of less than 2%. Bankers, taking money from the government, are happy to lend it back to them. But the forces of the correction are giving up little ground. While stocks rally, the real economy remains in a funk. "Sharp drop in start-ups," is a news headline from yesterday. New business start-ups are a major source of new jobs. Bad omen. Even glamour publisher Conde Nast is forced to make cutbacks. It has told employees that they may not spend more than $1,000 a night when they are traveling. A Pimco economist says savings rates are still going up...and may exceed 8%. This represents hundreds of billions of dollars taken out of the consumer economy. Oddly, while it makes the slump worse, it also helps finance the government's battle against it. Savers buy US debt (albeit indirectly). So, the battle is still going on...and the outcome is still in doubt. [We may not know how this battle is going to turn out, but we do know one thing: it most likely won't turn out well for you...which is why we have made a financial defense strategy available to our readers - free of charge. Get it here.] More news, from The 5 Min. Forecast: "Pop quiz: what happened a year ago today?" writes Ian Mathias in today's issue of The 5. "Here's a hint: "The House put the kibosh on the first rendition of 'The Emergency Economic Stabilization Act of 2008' - Former Treasury Sec'y Hank Paulson's three page request for a $700 billion blank check for his buddies on Wall Street. "'Investors' threw a tantrum, crashing the Dow 777 points - it's biggest point loss in history. Approximately $1.2 trillion in Wall Street shareholder value was wiped out, also a record. This day a year ago, the real market pain began. The S&P fell about 20% over the next two weeks. "The House eventually passed a package - aimed at cleaning up 'toxic assets' on big Wall Street balance sheets, but also rife with pork barrel spending. A year later...the stock market has recovered, Congress has spent plenty o'money, but has anything been done to stave off future CDO or mortgage-backed calamity? No. "Time and clever accounting has put us deservedly back to square one...right? Or, as Addison argues in his latest investment report, is this the 'biggest financial swindle in world history, engineered by none other than Wall Street and Washington, DC.'" And back to Bill, with more thoughts... Our own Addison Wiggin was interviewed by The Daily Bell on his beginnings at Agora (working on an old laptop on a desk he shared with your editor in Paris), whether or not the West can save itself - and on this 'war' between inflation and deflation. On the latter, here's what Addison had to say: "'Deflation now, inflation later' is a mantra we've adopted at The Daily Reckoning. The Federal Reserve, through it's program of quantitative easing, is busting the seems of it's own balance sheet in order to fight a deflationary trend in the West. At some point, the tide will shift. Mr. Bernanke assures the world he's watching inflationary indicators like a hawk. We have our doubts whether those indicators will do him any good. As Paul Volcker, the great inflation slayer of the early 1980s, said when we interviewed him for I.O.U.S.A. 'Once inflation gets started, it's very hard to stop. And there's a strong flavor of that at the moment.' [To read Addison's full interview, see here.] "Global trade rose at its fastest rate in more than five years in July," The Financial Times reports, "suggesting the economic recovery is feeding through into commerce." "I've been worried about the effects of protectionism in shutting off different markets and making a weak economy even worse off," says colleague Chris Mayer. "Commodity markets especially need open markets to function well. The EU, for example, just put a 40% tariff on Chinese made steel pipe. That's not good for steel pipe demand and hence, the steel makers and the commodities that go into steel. If we see widespread adoption of such measures, we'd have to re-think some things. "But so far, it looks like we've got a recovery of some kind in global trade. When I look at the global economy, many of the bright spots stem from surging trade along old trade routes (such as China and Arab world)." [For more from Chris, and to learn about a resource breakthrough that could change the face of America's dependence on foreign oil, see here.] Racehorse prices are in freefall, says a report out yesterday. But collectible cars are still doing well. Yesterday, we saw someone drive by in a huge, gaudy pink Cadillac from the 1960s. It had magnificent fins and enough chrome to stagger a blind man. In it were a middle-aged man and woman, looking very comfortable and proud. They were traveling in style...in a rolling sculpture. Old cars are not only holding their values, they're still going up. But not all old cars. Detroit's muscle cars have been falling in price for the last three years. Not very green? Until tomorrow, Bill Bonner The Daily Reckoning The Daily Reckoning PRESENTS: At present, there is a lot of confusion amongst the investment community and opinion is divided as to whether we will witness inflation or deflation. Puru Saxena looks at both sides, below... Inflation is Our Future by Puru Saxena Hong Kong, China On one hand, the deflationists are claiming that given the extremely high debt levels in the West, further inflation is impossible. On the other side of the argument, many proponents of inflation are calling for Zimbabwe style hyperinflation. In this business, everyone is entitled to their opinion; however it is my contention that we will get neither deflation nor hyperinflation. If my assessment is correct, once business activity picks up, our world will have to deal with high inflation. Although I have great sympathy for the deflation crowd, given the reckless attitude of the central bankers and their ability to create debt-based money, I do not believe deflation (contraction in the supply of money and total debt) is very likely. For sure, in this post-bubble environment, American consumer debt continues to contract, but this is being more than offset by the expansion in federal debt. Over the past year alone, federal debt in America has surged from US$9.645 trillion to US$11.813 trillion. In other words, during the past twelve months, American federal debt has risen by a shocking 24.47% and it now stands at 83.52% of GDP! Now, given the ability of the American establishment to essentially create dollars out of thin air, I have no doubt in my mind that it be able to inflate the economy. However, this will come at a huge cost and the victim will be the American currency. In fact, the recent weakness in the US dollar is a sign that central- bank sponsored inflation has started to dominate the private-sector debt contraction in the West. Furthermore, over the past few weeks, various governments have issued US dollar-denominated debt and this suggests that the carry-trade is back in vogue. In a startling move, Germany recently announced that it plans to borrow money in US dollars! Now, given the ongoing federal debt inflation, debasement of paper currencies, sky-high budget deficits and competitive currency devaluations, the macro-economic environment has never been better for precious metals. Yet, both gold and silver continue to frustrate the bulls by staying below the record-highs recorded in spring 2008. So, what is going on here? Have we already seen the end of the precious metals bull-market or are we about to witness an explosive rally? Before I attempt to answer this question, I want to make it clear that even though gold failed to better its all-time high during last autumn's panic, it was the only asset, (apart from US Treasuries) which stayed relatively firm. And looking at the various markets today, gold is the only asset that is flirting with its all-time high. So, whether you like it or not, gold deserves some credit for fulfilling its role as a safe haven. "...when macro-economic uncertainty was high and inflationary expectations were running out of control, gold turned out to be a fantastic asset to own. If my take on the macro-economic situation is valid, then we are in such a period now and gold must form a part of every investment portfolio." Now, unlike some of the die-hard gold bugs, I don't believe that gold is the ultimate asset to own at all times. Without a doubt, there have been times in history when gold has proven to be a lousy investment. For instance, between 1980 and 2001, the nominal price of the yellow metal fell by an astonishing 70%. This horrible price action spawned an entire generation who grew up hating gold and up until a few years ago, the vast majority considered gold a barbaric relic. However, during other periods in history, when macro-economic uncertainty was high and inflationary expectations were running out of control, gold turned out to be a fantastic asset to own. If my take on the macro-economic situation is valid, then we are in such a period now and gold must form a part of every investment portfolio. You may remember that over the past year, central banks have injected trillions of dollars into the banking system and it is only a matter of time before inflationary expectations start spiraling out of control. Up until now, this 'stimulus' money hasn't permeated through the economy in the West but once money velocity picks up, prices will start rising and the investment community will become very concerned about inflation. When the deflation scare abates and people start protecting the purchasing power of their savings, capital will start to flow towards precious metals. Long-term clients and subscribers will recall that about two years ago, I highlighted gold's tendency to rocket higher every other year. Figure 1 captures this trend perfectly and you can see that since the outset, gold's bull-market has been punctuated by lengthy consolidations and the yellow metal has surged to a new high every alternate year. Figure 1: Is gold about to shine? So, if gold remains in a bull-market and its trend consistency is intact, its price should surge over the following months. Conversely, if the price of gold fails to climb above its all-time high before year-end, it should start to ring alarm bells as this would open up the possibility that the bull-market may be over. Remember, certainty does not exist in the investment world and savvy investors should remain open to all outcomes. Now, given the uncertainty in the world today and the ticking inflationary time-bomb, my view is that gold will soon embark on its north-bound journey. So, I suggest that investors hold on to gold and the related mining companies which will probably continue to perform well until next spring. As far as silver is concerned, it has always been a high-beta play on the direction of gold. If the next up leg in gold's bull-market materialises, the price of silver will also head towards the heavens. Accordingly, investors may also want to allocate a portion of their investment portfolio to silver bullion and silver producing companies. Regards, Puru Saxena for The Daily Reckoning Editor's Note: In a good year for gold, silver could bring in some pretty major gains. Find out how to include this precious metal in your portfolio. See here. Puru Saxena is the founder of Puru Saxena Wealth Management, his Hong Kong based firm, which manages investment portfolios for individuals and corporate clients. He is a highly showcased investment manager and a regular guest on CNN, BBC World, CNBC, Bloomberg, NDTV and various radio programs. Puru Saxena publishes Money Matters, a monthly economic report, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly report, subscribers also receive "Weekly Updates" covering the recent market action. Money Matters is available by subscription here. The Daily Reckoning - Special Reports: Gold: The Truth About Gold Fiat Currency: Using the Past to See into the Future "THE GREAT AMERICAN RECOVERY RP-OFF" Brace yourself for what's about to go down as the BIGGEST FINANCIAL SWINDLE in world history.

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