Now Entering the Political Stage

by Bill Bonner
London, England

"Politics is about what works," someone once said. Perhaps it was Hillary Clinton. Someone said it...someone who is an imbecile.

Politics is not about what works, it's about what you can get away with. And what you can get away with is often exactly what doesn't work at all.

Our beat is money, here at The Daily Reckoning. We specialize in fraud and folderol. We leave the homicide beat to someone else.

What the United States is getting away with, from a financial point of view, in addition to counterfeiting, is grand larceny on a Super-Madoff scale. It is borrowing trillions of dollars even though it has no way to honestly pay back the money.

Still, so eager are the lenders to part with their money that the yield on the 10-year T-note fell yesterday to 3.64%. The more the feds borrow, apparently, the more lenders are willing to lend.

We're in the third and fatal stage of a great country - the political stage. In this stage, money and power migrate from the financial community to the political community. The politicians get away with taking trillions out of the productive economy and spending them on their pet projects and private corruptions.

Warren Buffett described the America of the bubble years as "Squanderville." Private citizens were living beyond their means, he pointed out. But he hadn't seen nothin'. Now, government does the squandering. The politicians are spending trillions they don't have on projects nobody was willing to pay for even when they had some money in their pockets.

What the government can get away with now - under cover of a financial crisis - is a big grab for money and power. It 'works' in the sense the feds are able to get away with it. But it will prove fatal to the dollar...and to the US economy.

We will return to that subject below...

Back in the markets, the Dow fell modestly yesterday, down 16 points. Oil clung to the $69 level. Gold was up $3 to $924. And the dollar saw its biggest drop in weeks as speculators waited for word from the Fed on its next move.

The Fed is expected to talk about an "exit strategy." It is intervening in markets as no Fed ever has. Its balance sheet - a measure of how much intervention it has done - has shot up in a way that is not only unprecedented, but also almost unbelievable. In an effort to provide liquidity, it has bought up the contents of every neglected refrigerator on Wall Street. The smelly, furry stuff - "toxic" derivatives...SIVs...MBAs...no one seems to know exactly what it is - enters the Fed's books as an asset. Altogether, along with its not-so- pungent holdings of US Treasury bonds, the Fed's balance sheet shows more than $2.7 trillion worth of assets.

"It's not sound economics - nor is it ethical - to trash the US dollar and bail out incompetent investors who poured billions into CMBS at the peak of the bubble," says Strategic Short Report's Dan Amoss. "There is no longer a 'systemic risk' argument for The Fed to be propping up the price of such securities.

"However, as the stock market falls and the economy weakens, we should expect the Fed to step on the accelerator again. I find it useful to think about the Fed's role in such terms; as fear of inflation grows, the Fed will tap the brakes on its monetary debasement, and as fear of deflation grows, it will push the accelerator to the floor, if need be. The endgame under this tragic scenario is the eventual destruction of confidence in paper money, rapidly rising import prices for US consumers, and lower standards of living."

Read more from Dan here.

What happens next?

We don't know. But it is far too early to worry about it. The Fed is in no position to head for the exit. It will have to stay on this road for much, much longer.

Why? Because the "green shoots" are shriveling up. There is no real economic revival. And there can't be one until the underlying problems are corrected.

More news from The 5 Min. Forecast:

"Yesterday and today, the market's been on pins and needles," reports Ian, "anxiously awaiting a new plan (or lackthereof) emerging from the Fed's latest gathering. While Bernanke and his brood are out of rates to cut, they still have some face cards up their sleeves - like purchasing agency debt or US Treasuries, or new lending programs with our beaten-down banks. We've even heard some calls for direct mortgage market manipulation.

"We expect whatever the Fed has to say will have some notable effect on Mr. Market - new money pumping programs could lift stocks and hurt the dollar, while no news should do the opposite. But we looked at this chart today and asked ourselves, does it really make a difference?

"Irrespective of near-term currency market gyrations and central bank intervention," adds John Williams of ShadowStats fame, "the dollar is ultimately headed much lower against the major currencies. Such helps to generate inflationary pressures in the United States that are not reflective of strong economic activity."

The 5 Min. Forecast took today off, as the Agora Financial editors and analysts are once again gathering at our Baltimore HQ for our bimonthly editorial meeting. Unfortunately, this meeting is closed to the public - but you can catch up with all of Agora Financial's best and brightest at this year's Agora Financial Investment Symposium in Vancouver, B.C. The symposium promises to be the event of the year - so don't miss out! Secure your ticket now - before the event sells out! See here:

Agora Financial Investment Symposium, July 21-24

And back to Bill, with more thoughts:

One of the big problems is too much capacity. We mentioned it yesterday. During the Bubble Epoque the squanderers would buy anything. So, you could make an almost unlimited amount of money by providing them with things to buy. This meant building factories...buying trucks...and renting retail space. Now, however, the squanderers have come to their senses. They want to save their money. So, no need for so much retail space in the malls, so many trucks on the highways or so many factories in China.

America's middle class has rediscovered thrift.

There are a number of sit-down restaurant chains that cater to the middle class - Applebee's...Chili's...Ruby Tuesday and a few others. They expanded greatly during the '90s and '00s in order to meet the desires of the big spending masses. But now that the masses aren't so free and easy with their money, The New York Times reports that they are in desperate competition for remaining diners. This competition is manifesting itself as price deflation.

Applebee's offers dinner for two for only $20. Chili's advertises entrees for just $7. Ruby Tuesday's is going for a 2-for-1 deal. Buy one meal, get one free. All of them are making heavy use of discount coupons.

Oversupply is producing deflation. Prices are falling as suppliers fight for demand by offering more for less. And over at the Red Roof...the roof has already caved in as the chain has defaulted on its mortgage debt.

This is what you'd expect at the end of a long period of credit expansion. EZ credit brought forth too much demand and too much supply. Now, the demand is disappearing...and the suppliers struggle to hold on.

Even now, we're facing an economy in which 70% of our economic output depends on consumer buying. No buyers, no recovery.

This is natural, normal and perhaps necessary to a market economy. And it will take years to sort out. Roofs have to fall in on thousands of enterprises, speculators and households. Then, the rebuilding can begin.

(In the meantime, The Richebacher Letter's Rob Parenteau tells us that there is a move you can make to protect yourself (and profit) during any further downturn in consumer sales. See it here.)

But the Bernanke Fed is not about to let nature take her course. The Fed is on the road to ruin...and it's not about to "exit" yet. Deflation is still enemy number one. Don't expect any tightening from the Fed anytime soon, dear reader...it is far too soon for that.

Governments are essentially parasites on productive activity. So the best governments are the smallest - meaning, the least parasitic. "That government is best which governs least", is how Jefferson put it.

But now we are in the third and fatal stage of a great country - the political stage. In this stage, the parasites take over. Government governs a lot. And governing a lot costs a lot of money. In England, the government budget is bumping up against half the total GDP of the nation. In America, health care is still largely a private matter, so the government spends a smaller percentage of GDP...but it is a percentage that is rising quickly.

Where will the money come from? Taxes. Gordon Brown has already put the income tax rate up to 50%. Michael Caine, an English actor who moved to California to escape the high taxes of the '70s, says he will tolerate 50%...but not a penny more.

"If it goes to 51% I will be back in America," he says.

Ahem...he might have to try somewhere else. Everybody's gunning for the rich - in America as well as England. Obama has pledged to raise taxes on the rich. The states, notably California, are desperate for more revenue too. Add federal, state and local levies...and private health care costs...and you could easily be over the 50% bracket in America too.

But when you rob the productive Peters to pay the parasite Pauls two things happen. The Peters get their backs up. And you've soon cleaned them out anyway.

So, governments need to find other sources of financial support. Typically, they borrow money.

The history of European monarchies is largely a history of debt. Kings and queens squeezed what they could out of the turnips. Then they turned to the moneylenders. These lenders had to be careful. They were happy to extend monarchs credit, because in this way they gained a measure of control over them. But there were many dangers. Kings lost their heads...or went broke. Or, often, the monarchs could turn the tables on the moneylenders...and have their heads cut off. Reading the history of the loans to the French crown it is eye-opening. It is amazing anyone wanted to lend at all. The risks were great; the rewards were few. Rarely were the loans settled honorably.

What you come to see is that lending to the government - which always has the power to betray the loan and behead the lender - is merely another form of taxation. Government raises money. Sometimes it repays the loan with revenues from other taxes. Sometimes, it is the lender who pays the tax himself - either because the government defaults...or because inflation reduces the value of his money.

This week...indeed, this year...lenders are turning over massive amounts of money to the US government. There is so much demand for US paper that the yield on the 10-year note fell yesterday to 3.64% - despite the huge new supply of T-notes coming on the market. It is breathtaking to watch. But it is a story that will end badly. We predict that lenders will end up like the financiers who lent to Louis XIV and later regretted that they ever met the man.

"Every loan always diminishes the free revenue and necessitates, at the end of a certain time, either bankruptcy or the increase of taxes," explained Turgot to a later Louis. "In times of peace it is permissible to borrow only in order to liquidate old debts, or in order to redeem other loans contracted on less adventurous terms."

Any borrowing in excess of that puts you on the road to ruin, Turgot went on to explain.

More on Turgot - a man sadly neglected by historians - in upcoming reckonings.

Until tomorrow,

Bill Bonner
The Daily Reckoning

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The Daily Reckoning Presents:

There can be no doubt that the global economy is undergoing a massive transformation and we have now entered an era of 'Big Government'. Puru Saxena explores, below...

Transfer of Wealth
by Puru Saxena
Hong Kong, China

After decades of excess credit and over-consumption, the developed world is finally being forced to deal with private-sector deleveraging. However, the governments seem to have other plans and they've decided to fight these deflationary forces tooth and nail. Their solution - even more credit and consumption!

Rather than accept a painful adjustment period, policymakers are desperately trying to revive the party. And in the process, they are making the situation much worse. All over the world, governments are spending trillions of dollars in order to clean up the mess. Unfortunately, the stark reality is that these governments have no money. So, in most instances, these glorious state-sponsored spending programs are being financed by borrowing and money printing.

Most people seem to forget that these fiscal spending programs aren't creating any real wealth and are simply transferring wealth from the savers to the debtors. Essentially, governments are taking money from the solvent and re-distributing these funds amongst the insolvent.

Needless to say, by bailing out the incompetent and buying their toxic assets, the governments are cleaning up the private-sector balance sheets but at a huge cost. In the process of saving a few 'too big to fail' corporations and their bondholders, policymakers are greatly increasing the risk of sovereign defaults. In a nutshell, policymakers are erroneously transferring private-sector risk to the state.

"As the private sector continues to pay back debt, the use of the printing press won’t result in immediate inflation. However, over the medium-term, all these needless bailouts are going to create a massive inflation problem."

So far in the ongoing credit crisis, we haven't really seen many sovereign bankruptcies but I suspect they will follow. And you can bet your bottom dollar that policymakers will not hesitate to use the printing presses if it results in escaping sovereign default. As a result of the world's banking system being a multiple of world GDP, the sad truth is that politicians don't have very many options.

What we've witnessed over the past few months is that governments around the world have decided to maintain the stability of their banking systems in order to preserve the trust of their populace. Basically, policymakers have opted to save the banks even if it means putting entire nations at a great risk. And the most likely outcome is that the politicians will continue on this inflationary road to nowhere.

In my opinion, as the private sector continues to pay back debt, the use of the printing press won't result in immediate inflation. However, over the medium-term, all these needless bailouts are going to create a massive inflation problem.

Amidst all this economic uncertainty and rampant money printing, confidence in governments will plummet and people will turn to 'old fashioned' stores of value - those assets which represented money long before pieces of paper backed by empty promises became fashionable. Indeed, the investment community has already begun moving towards precious metals and I expect this trend to continue.

It is interesting to note that only 160,000 tons of gold has ever been mined from the face of this planet and at US$950 per ounce, it is worth US$4.9 trillion. Now, consider that the total amount of paper money in circulation (currencies, savings, deposits, money-markets and CDs) is worth US$60 trillion or approximately twelve times the value of the gold in existence. Now, there is no doubt in my mind that as world governments debase their currencies, many people will begin to question the viability of paper money as a store of value and they will turn to gold, silver and platinum. Even if a small fraction of paper money rushes towards the small gold and silver markets, what do you think will happen to their prices? No question, precious metals' prices will explode!

Accordingly, I sincerely recommend that investors allocate at least 10% of their wealth to physical bullion. Over the next few days, it is likely that precious metals will correct and this may be the final opportunity to buy gold and silver at these levels. Those looking for extra leverage should invest money in the precious metals mining stocks. So far in the precious metals bull market, we've had massive rallies every two years. If this trend remains intact, after the usual summer correction, we should see an explosive move until spring next year.

Regards,

Puru Saxena
for The Daily Reckoning

Editor's Note: If you are looking for gold to turn you a tidy profit - not just act as a hedge against the falling dollar or the threat of inflation, then you'll want to read this special report. Get it 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 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.

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