Kurt Richebächer died two weeks ago at his home in Cannes, France, at 88 years old. R.I.P.

One of our greatest complaints is the way the modern world pays homage to its dead. When a good man finally has the mud tossed on his face, he is almost instantly forgotten; so little notice is taken, it hardly seems worth dying. Meanwhile, those who are widely mourned and greatly regretted usually don’t deserve it. When Paris Hilton dies, for example, America will probably declare three days of national mourning and hang black crepe on the capitol.

Kurt Richebächer met his end with hardly an “ave” from anyone but friends and family. We pause to remember him here for both sentimental reasons and practical ones. On the sentimental side, we remember him as an old friend and fellow idealist. On the practical side he, and practically he alone, understood the worldwide economic boom for what it really is – a sham.

Kurt Richebächer was born at the wrong time, in the wrong place. He came into this life in the middle of WWI, on the losing side. He was a young man when another losing war got underway. He was one of the generation who were plucked up by the Wehrmacht in ’39…and lucky to still be alive by ’45. Kurt was lucky, in a way. He suffered a disabling accident while still in training. He spent the entire war in various military hospitals, unable to walk; the rest of his life he walked only with a cane. Doctors didn’t know exactly what was wrong with him; at one point German military officials threatened to prosecute him for malingering. Had Kurt’s father, a Nazi party member, not intervened, he might have been shot. Instead, in his hospital bed, he began to read economics.

The classical economics texts Kurt read made sense to him. They described not merely the world as it was, but the world as it ought to be. They emphasized discipline, hard work, and capital formation as the essential elements of wealth creation. And they warned against excess credit and inflation as if they were loose women and demon rum; both were sure to lead to ruin.

The war over, Germany threw off the bad advice of its American overseers. The deutschemark was made a rock-hard currency. Germans clove to the old economics. The country prospered. And Kurt Richebächer rose to be chief economist for Dresdner Bank.

But then, in the 1970s, classical economics – known as the Austrian School today – was going out of style, even in Germany. Economists – those in the United States and Britain – found they could upgrade their trade. Instead of merely reminding people of the old, un-yielding truths they began offering new tricks and innovations. They promised not merely to explain how the world works, but to make it work better…by taking the devil out of it and making it a more agreeable place. Using their new tools, econometrics and statistical analysis, they believed they could manage an economy, so as to achieve full employment and steady growth forever.

Kurt saw the new trends in his profession as dangerous; he regarded their proponents as quacks.

“You anglo-saxons…” he said to us once… “you just have no concept of financial discipline. Just look what you are doing – at every level. In Europe, we have high levels of state debt, but at the individual and business level, our balance sheets are pretty strong. But in almost every English-speaking country, people borrow for everything.

“All this emphasis on statistics and calculations…,” he went on, rapping his silver-handled cane on the table for emphasis, “without a proper theory, it is all nonsense. And your economists seem to have no theory at all…they just think they can manipulate the system in order to get whatever outcome they want. They think economic growth comes from consumer spending and that they can control consumer spending by adjusting lending rates. It is unbelievable that anyone takes this seriously. It is capital formation that really matters. A rich society is one with a great stock of capital…one that builds capital and puts it to work to create more capital. A rich society is not one where people consume. Just the opposite. It is not what is consumed that creates wealth; it is what is NOT consumed. Yet, all the Anglo-Saxons focus on motivating consumers to consume. And now they are consuming more than they make. I tell you, in 70 years of studying economics, I have never seen such nonsense.

“I have always thought it was the duty of each generation to leave the next one a little better off. That means, each generation has to consume less than it produces. It has to leave a little something extra. The problem, you see, is not an economic one…what we are doing to our children with this use of credit and debt is deeply immoral. It is wrong. It is wrong to burden the future with our mistakes, our conceits, our ambitions. This is what we are doing, and it is shameful.”

Kurt warned against the bubble in tech stocks in the late ’90s. Then, he warned against the great bubble in housing. In September 2001, he wrote: “The new housing boom is another rapidly inflating asset bubble financed by the same loose money practices that fueled the stock market bubble.”

In one of his final letters, he concluded, “The recklessness of both borrowers and lenders has vastly exceeded our imagination.”

He went on to predict “that the housing bubble – together with the bond and stock bubbles – will invariably implode in the foreseeable future, plunging the U.S. economy into a protracted, deep recession.”

Paul Volker once remarked that the challenge of modern central bankers “is to prove Kurt Richebächer wrong.” Instead, they are proving him right.

BILL BONNER

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.

Bill’s latest book, Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics is available for preorder now by clicking here:

Mobs, Messiahs and Markets
http://www.agorafinancialpublications.com/Mobs.html

***
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by Nathan Lewis

Despite claims to the contrary, proper currency management is simple. A currency’s value is determined by the balance of supply and demand. The currency is supplied by the issuer of currency, which today are central banks. The currency is demanded by anyone worldwide who wishes to hold the currency.

Whenever supply is growing relative to demand, the currency loses value. Whenever supply is shrinking relative to demand, the currency gains value. When supply maintains an equal relationship with demand, stable currency value results.

Everybody knows that if a central bank increases supply (i.e., “prints money”) willy-nilly and far in excess of demand, the currency’s value will fall. However, this is not the only means by which inflation can take place. If demand shrinks and supply does not shrink accordingly, the result is that supply grows relative to demand and the value of the currency falls. It is possible for the currency’s value to fall even when supply is shrinking—if demand is shrinking even faster.

A fall in supply relative to demand will push the currency’s value higher. This can happen through a contraction of supply, but it is also common to find that the demand for a currency can increase sharply. This will raise the currency’s value even if supply is stable or growing.

All fluctuations in a currency’s value, which can be noted in the foreign exchange market and currency’s exchange rate with gold, are the result of the mismatch of supply and demand.

Money is supplied by institutions with the power to create money. In the past, private commercial banks created money. At other times, money has been created by government treasury departments or ministries of finance. Today, money is created by central banks, although central banks were not created for that purpose.

Today, money is rarely printed in the first instance, but rather comes out of a very special checking account at the central bank that nobody puts any money into. The central bank will buy something on the open market, usually either domestic government bonds or foreign currencies, and will pay for the purchase with its magic checking account, creating an increase in the seller’s bank account. In a normal transaction, A has a bond and B has $1,000, and afterward, B has a bond and A has $1,000. The amount of money in circulation does not change. However, if A sells the central bank a bond, A’s account is credited with $1,000, but no account is debited. New money enters circulation. This money ends up as bank reserves, which can be redeemed for paper banknotes on demand. If the government does not have sufficient paper currency in its vaults, it prints new currency to meet this request. Thus, increasing the money supply by buying bonds with the magic checkbook is equivalent to printing money.

Supply can be reduced through the opposite process. If the central bank sells a bond to A, A’s account is debited, but no account is credited. The money simply disappears. One can imagine the issuer of currency “running the printing press backward.” Central banks

today have enough bonds or other assets to buy back the entire supply of money available. The U.S. Federal Reserve, for example, can buy up every single dollar in the world. Thus, it can supply any amount of money, from zero to infinity.

Even if a central bank, or government, did not have enough assets to purchase currency, it could issue new bonds or eliminate currency taken in from tax revenues.

The central bank is in a nice position here. It can buy things with money it simply creates out of nothing. The profit inherent in producing money is known as seignorage, a word signifying that it has long been considered the right of kings. However, it does not have to be done by governments. Many of the early commercial banks, in eighteenth-century Scotland, for example, specialized first in printing paper money (replacing metallic coinage) and only later diversified into making loans. As private institutions, they profited from money creation in the same way that governments profit today.

Today, the interest income from the roughly $800 billion of government bonds held by the privately owned Federal Reserve is remitted to the U.S. Treasury, after deducting the operating expenses of the central bank. (At least, that is the official story.)

The money that is created by the Fed’s magic checking account is known as base money and consists primarily of Federal Reserve Notes (i.e., paper currency, dollar bills) and bank reserves, which are deposits of commercial banks with the central bank and are recorded electronically at the central bank. Only the Fed can create base money, and the Fed can create no other type of money except for base money. Paper bills make up the majority of base money. At this time, the U.S. Federal Reserve counts about $812 billion of base money, with $750 billion in bills and coins, and $62 billion in bank reserves. During the 1990s, U.S. base money grew at an average rate of 7.14 percent per year.

The term base money is used because upon the base of base money sits a much larger pyramid of credit. A bank deposit is not money, but is actually a kind of debt instrument, a bond that must be repaid at the request of the lender, called the depositor. As a bond, it pays interest. While the amount of base money available is determined to the dollar by the central bank (at least insofar as bills are not destroyed or lost by their holders or created by counterfeiters), the amount of existing credit can change according to a nearly infinite number of factors.

Thus it is incorrect to say that “banks create money.” Only the Federal Reserve creates base money. Banks can only create credit, which does not alter the supply of base money, but which may have an effect on the demand for base money. Actually, anyone can create credit, simply by making a loan. Credit is not money.

Editor’s Note: Nathan Lewis was formerly the Chief International Economist of a firm that provides investment advice to institutional investors. Today, he is part of the investing team at an asset-management company. He has written for the Financial Times, Asian Wall Street Journal, Daily Yomiuri, Japan Times, Pravda, Dow Jones Newswires, and other publications. He has appeared on financial programs in the US, Asia, and the Middle East.

This essay is an excerpt from Nathan Lewis’s new book, Gold: The Once and Future Money. Click here to get your copy today:

http://www.agorafinancialpublications.com/GoldBookDR.html

by Kevin Kerr   

Sometimes when I turn the TV on and listen to the commentators talk about commodities I cringe. For years the media treated commodities as a secondary asset class, or worse, a form of legalized gambling – to some extent they still do. Their understanding of how the markets actually function is rudimentary at best. Now I’m not saying these journalists are not intelligent – some of them are brilliant. They just don’t understand how the commodities markets work. But yet they have such power that when the camera light goes on millions of people hear and believe what they say. Having done a lot of television and print media myself, I know that they can be very powerful tools but, as they say in the Spiderman movies “with great power comes great responsibility.”    

Anyway, let me be clear – I make use of the media and information superhighway every day. While I have colleagues who are deep philosophical thinkers who don’t even own a TV, I have five computer screens in my office and two televisions. Does this make me non-philosophical and obtuse? No, because most of the time I keep the volume on the TV down, which improves my IQ immensely.    

Distractions of any sort when trading can be of little or no value. The TV blaring opinions that change moment-to-moment can be one of a trader’s most useless tools. A friend and colleague of mine, we’ll call him Jack, used to work in the office across from mine. Jack is one of the best currency traders I know and he and I come from the same mold. Jack never had a TV in his office; he thought it was worthless and that what was said was mostly drivel. For the most part he was right. More importantly, Jack’s point was that TV offered him nothing beneficial for his trading–it only interfered with his system and was a distraction; in other words, just noise. I agree with Jack. I also feel that staring at a trading screen all day long is useless.    

Markets move up and down and when they move against you, when the screen is totally red, emotion can creep in, and we all know how detrimental that can be. I suggest sometimes that you simply switch off the screen and do something else. Pet the dog, make a sandwich, go to the gym, make another sandwich (there have been some years where I’ve gained 20 pounds!) – my point is to leave the scene and clear your head, then come back and decide what to do. You may be amazed at what you find when you return!

Jack was a funny guy; he had very little in his office: a little box over in the corner, a few books on the desk, a light and that was about it – maybe one picture of his family. Truly a minimalist. My office, on the other hand, had tons of stuff in it–pictures books, plaques, TV blaring, etc. So one day I went into Jack’s office and I asked him “Not for nothing Jack, but what’s the box for, and why don’t you keep more stuff in your office?” He looked at me and said, “I can fit everything I have in this office in that little box in about two minutes.” Jack’s point was that he wanted to be ready to go at a moment’s notice. After being a professional trader for a number of years you come to learn that no matter where you’re working as a trader it all comes down to results, you’re only as good as your last trade.    

Now is that true? No, but it’s the perception. Truthfully, the media can be an invaluable source of new information and also a good contra-indicator. In other words, if everyone on TV or in the press is talking about how strong copper is, or crude oil, it may be time to look for a downside move, not always, but sometimes.   

My advice is to use the news and information as a resource; pull out what you need and leave the rest behind. It’s quite possible to be bombarded 24/7 by talking heads and then have no idea what to do. The best plan is to pick one or two trusted information sources, then lay out your own disciplined game plan and stick to it. Alter it occasionally but never stray too far or too fast. You can always hit the mute button on the TV–sometimes that’s your best move.   

You’ll preserve more of your sanity if you tune out all of the opinion and stick with the facts on which you should have based your trades in the first place. Moving your positions with every sound byte on TV only makes one person rich – your broker. Don’t do it!

In the world of commodities, figuring out which data NOT to look at can be just as important as knowing what you absolutely must follow on a regular basis. Each commodity is different and learning what’s important for corn is a lot different than learning what you need to watch for crude oil. Government numbers such as employment data, GDP, and Federal Reserve announcements impact almost all markets, even the global ones. It’s important to have an understanding of the key reports and, even more essential, how much emphasis the markets place on them. Certain reports carry more weight with traders than others.   

In addition, as a market changes and matures, certain reports may lose their relevance and new ones may come into play. For example, back when I started in the crude oil markets, everyone followed the American Petroleum Institute report (API), the benchmark report for oil inventories. Not anymore. These days, traders monitor the Energy Information Agency (EIA) report.    

Key government reports have been around for as long as the markets and they rarely change. Unemployment numbers, trade deficit, GDP, consumer sentiment. These all are major indicators of the state of the economy, and traders should know when these numbers are going to be announced or published.    

I’ve found that the hardest part about any information or number is not only understanding what it means but, more importantly, anticipating how the markets will react to the data. The second part of this equation is a thousand times more difficult than the first.   

For example, if the EIA data for crude oil comes out on a Wednesday morning and it shows a build in crude oil supplies, will the market perceive that as bullish or bearish? In other words, if the report shows more crude oil on hand than expected, you would think that would tell traders the market is heading lower. Not always. Sometimes traders may figure that OPEC will see that supply is higher and immediately cut production, which will have an impact on supplies down the road. So while the front couple of months may drop in price, if you own futures further out they actually could go higher. Commodities trading is like one big chess game; I advise being the knight, not a pawn. You always need to be flexible and agile when trading “off of the numbers.” Remember not to get tunnel vision and don’t fight the trend after a number, chances are very good that the trend will win.    

“Buy the rumor, sell the news” is a common traders’ saying, and for good reason. But once again this is not always the best advice. Sometimes what happens is that the markets will already “price in” the anticipated data; then when the numbers are released it’s a bit of a letdown from the hype before the number, thus “buy the rumor, sell the news.” Another favorite old-time saying I used to hear was, “Those who trade headlines end up selling newspapers.”   

Here are some of the key reports professional traders follow:    

Commitments of Traders (COT) – A report published every Friday by the Commodity Futures Trading Commission (CFTC) that provides investors with up-to-date information on futures market operations and increases the transparency of the exchanges. This is one report that traders rely on heavily, and so should you.   

Volume and Open Interest – We talked about this. Open Interest shows us how many people are actually trading any particular market at a given time. The higher the open interest the safer, or at least more liquid a market is to trade.   

Commercials’ Positions – This shows what commercial and end users are doing. Commercials buy more than individuals, or sell more, depending on market conditions. Traders put a lot of stock into what the commercials are doing because they carry a lot of weight in the market and often control the majority of the open interest.   

Unemployment Claims – Jobs are the lifeblood of the economy so traders pay very close attention to these numbers.   

Interest Rates – Interest rates affect almost every aspect of people’s lives, especially borrowing, and that can impact the ability of traders to invest, so it’s important to keep an eye on the Federal Reserve at all times.   

More specific to certain commodities are reports such as:   

Cattle on Feed – Shows the number of cattle that are in the process of getting ready for slaughter   

Crop Progress Report – Shows the condition of the current corps and how and in what condition they may harvest.   

Crop Reports for OJ – Shows the orange crop estimates and potential damage from weather, pests, or disease.   

EIA Report for Oil – A weekly inventory report, appearing every Wednesday, for crude oil and products derived from it   

Natural Gas Inventories- Same as the EIA report for Crude Oil, except it comes out on Thursdays and only measures the amount of natural gas in storage in cubic feet.   

…and many, many others.    

Like any tool in our trading toolbox, these reports can help us make an educated trading decision, but remember they are only one tool. Putting all of your eggs in one basket is never a good idea. Take the numbers with a grain of salt and try to anticipate how the market will react to any given number release. It’s a good rule of thumb to be on the sidelines for any major announcement because trading ahead of a number is highly risky and often very unpredictable, but then again that’s what many investors want. As you gain experience, you’ll be able to see where you want to be.   

Regards,   

Kevin Kerr
for The Daily Reckoning   

P.S In Outstanding Investments, we often write about the most profitable ways to play the commodities and natural resource markets – and our readers have been quite pleased with the results. That’s why we’ve decided to package all of our commodity-related publications together in one easy package so you can effortlessly take advantage of the next leg of the massive commodity super boom.   

For a very limited time, you can get what we are calling the “Resource Reserve” for a ridiculously low price. But act now – this offer is only open to a limited number of people…and spaces are filling up fast. Click here for all the details

Editor’s Note: Kevin Kerr is the editor of two highly successful and acclaimed financial advisory newsletters, Resource Trader Alert and Outstanding Investments. A veteran commodities trader, Kevin uses his irreplaceable experience to advise his readers on a variety of commodities investments on a daily basis. Widely considered one of the nation’s top commodities gurus, Kevin’s expert opinions are routinely featured in the country’s premier media outlets.   

The above was taken from Kevin’s soon-to-be-released book, A Maniac Commodity Trader’s Guide to Making a Fortune. In the book, Kevin dispels the common myths and misconceptions about these markets, offering an insider’s view of what he calls “the last bastion of pure capitalism on Earth.” Whether you’re a novice or an experienced trader, Kevin’s down-to-earth, clear-cut guidance will make you more savvy, more confident, and more able to jump right in and grab those profit opportunities that are waiting for you. The book is available for pre-sale here:   

A Maniac Commodity Trader’s Guide to Making a Fortune   

by Bill Bonner   

Go tell the Cretins, you who read;

We took their orders, and are dead.

            - Based on inscription at Thermopylae, with apologies   

The Bush administration is hoping that the new film, 300, will give the troop surge a lift with the public. The film glorifies the sacrifice of 300 Spartan warriors who held back an invading army of over 100,000 Persians in 480 B.C.   

Choosing their terrain well, the Spartans managed to neutralize much of the Persians advantage; while the Persians had many, many more troops, they could only get a few of them to the line of battle at a time. But the Greeks could see they were on the losing side of this fight. The Thespians, fighting alongside the Spartans, withdrew while the Spartans decided to stay and fight to the last man. They might have done so as a purely military necessity, holding off the enemy so as to give their allies time to retreat and regroup; or they might have fought on simply for the glory of it. We don’t know.   

We do know that they managed to hold their ground for a couple more days, until a fellow Greek, Ephialties, betrayed them by showing Xerxes how to outflank his opponents. Then, the Persians got behind the Spartans and rained down arrows upon them until they were all dead.   

Leonidas’s body was recovered, beheaded and crucified. But the rest of the surviving Greeks were then able to take up the fight; and, in a number of calamities and misadventures, the Easterners were finally driven back across the straits to Asia Minor. Western civilization was saved.   

According to today’s neo-conservative apparatchiks, we are once again involved in an epic struggle – a clash of civilizations between the free West and the tyrannical East. Paul Wolfowitz, Douglas Feith, Richard Perle, Philip Zelikow – this handful of men (probably no more than 300 of them), pushed a bright, shining war on a dim yahoo of a president. Together, they see themselves like Leonidas at the Pass of Thermopylae, guarding our western way of life, without even getting their suits dirty. The sacrifice of others is worthwhile, they believe.   

But now, after four years with neither victory nor defeat in hand, it is too late for earnest criticism; instead, the time has come for gratuitous ridicule.   

The targets are many. For instance, against whom the war in Iraq is being waged (or why) has yet to be fully clarified. Every question on the subject brings a response that only deepens the mystery.   

But the costs are becoming clearer every day. So far, Britain’s Ministry of Defense admits to having spent 5 billion pounds on the war in direct costs. Indirect costs are sure to be many times that figure. America’s total is much larger – $505 billion of U.S. ‘taxpayers’ money’ has been spent or approved. The biggest of all liar’s loans?   

Of course, we are already in the Land of Lies. Neither the British taxpayer nor his American counterpart has any spare money; their taxes were already earmarked for other boondoggles. Still, the U.S. President asked for another $100 billion of it on Monday, and is expected to request $140 billion more for 2008, bringing the total to over $700 billion. Looking ahead, to the cost of caring for wounded and incapacitated soldiers, the whole thing is expected to cost more than $1 trillion.   

Since we’re tallying, we cannot fail to mention the cost in lives. 3,205 U.S. soldiers have died, and 134 British soldiers. More than 24,000 Americans have been seriously wounded. Iraqi casualties, if anyone is keeping score, may top half a million.   

Meanwhile, George W. Bush asked Congress for the latest $100 billion draw, without strings and without delay – or else the war might have to be called off, he seemed to warn. The politicians bent over and checked under the cushions, but the spare change they recovered came nowhere close to $100 billion. They are already facing budget deficits of a half a trillion over the next two years. Where would the extra money come from? What would the extra strain do to the finances of the nation…or to the value of the dollar? How was the investment expected to pay off? No one knew. No one even asked.   

But as for the strings, everyone knew exactly what the chief executive was talking about -even the chief executive himself. Lawmakers have come to see the war, not as a real war, but merely as just another spending opportunity, with live ammunition. To the latest demand for cash, the polls have attached a number of pork-barrel provisions, including $25 million for spinach growers, $100 million for citrus growers, $74 million for peanut storage, $4 billion for ‘emergency payments’ to farmers, and $283 million for milk subsidies. Who says there isn’t progress in human affairs? The U.S. congress has managed to improve upon the old Roman formula – they’ve combined bread, circuses and war in a single spending bill.   

Every war has its profiteers. Neither in love, nor in war do you stop to count the costs. But a phony war is a bigger opportunity than most, because there is no patriotic necessity to win. Unlike the Spartans, the Cretins know Iraq poses no real danger to the homeland. So everyone gets into the spirit of the war as it really is.   

Halliburton, Lockheed, and Bechtel inflate prices, take money for nothing, and gouge taxpayers for useless weapons and unnecessary supplies. In one report, truckers reported that they were asked to drive empty trucks back and forth across the desert, carrying sailboat fuel so that contractors could bill the government for delivery. A total of $9 billion has been officially lost or unaccounted for.   

War critics will complain about the waste of money involved. They will point to this week’s polls, showing the war to be so ineffective that the average Iraqi now regards democracy with suspicion, and finds it acceptable to kill U.S. and British troops. The more the U.S. government tries to improve the lives of the Iraqis, the more Iraqis seem to want to get even. Given the deadly drift of things, wasted spending may turn out to be the best spending the Bush team did.   

“There will be good days and there will be bad days,” said the American president, stoically. And he’s right…but they won’t be shared out equally. The spinach growers, milk producers, and weapons contractors will get the good days. The poor grunts, the Iraqis and the taxpayers will get the bad ones.   

But what about the Cretins? In the film, as in the battle, the Spartans were wiped out. “Spartans. Tonight we dine in hell,” Leonidas was said to remark. Later, a shower of arrows so thick they blotted out the sun, according to Herodotus, came down on them. The Spartans fell; but Greece was saved.   

We don’t know how far the parallels go. The U.S. military presence in Iraq hardly seems like 300 Spartans defending the homeland. Instead, it seems more like the Persian Empire invading someone else’s homeland.   

And the 300 Cretins? Are they really protecting western civilization? Was it worth the billions spent and the thousands of corpses? We don’t know, but we have a feeling that there is already a table reserved for them in Hell.    

[Ed. Note: If you would like to read more of the real story of the war between Greece and Persia, please refer to our very own book:   The Essential Classics]

Regards,   

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 Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons). 

In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount – just click on the link below:   

Empire of Debt 

by Dan Amoss, CFA

Paper money is popular under democracies. Under the control of a central bank, paper money provides modern economies with the illusion of great flexibility and resilience. Without the rigidity of the gold standard, bad bank loans are easily swept under the rug. This prevents the possibility of setting a Depression-era bank failure into motion.

Contrary to popular opinion, paper money is not wealth. Paper money is a claim on wealth. It only has value to the extent that it can be exchanged for things — a bushel of corn, a gallon of gasoline, a dental cleaning, or an Intel microprocessor.

When the government prints more money, it gives a public fixated on asset prices the illusion that they are growing wealthier, when, in fact, they are growing poorer. As paper money becomes more and more plentiful, the producers of valuable products will eventually demand more units of money in exchange for their product or service.

Daily celebrations of new Dow records fail to recognize the inflation behind this index’s move upward. Dr. Marc Faber is on public record talking about a potential “Dow 100,000” scenario. This scenario is possible if current trends continue. But we must remember that under this scenario, the price of everything will be increasing dramatically, leading to lower living standards.

Food Is Wealth, Pesos Are Not

A stark example of consumer price inflation leading to declining living standards is the recent tripling of corn tortilla prices in Mexico. Protesters have marched on Mexico City, demanding that the government do something about it.

Mexico’s fairly socialist economy has produced a situation in which many citizens’ incomes rely heavily on the government’s entitlement spending. Mexican monetary policy must remain loose to keep the system afloat. The supply of pesos in circulation has been growing 15-20% over the past year.

Misjudging the root cause of tortilla price increases — an exploding money supply — populist politicians have blamed “monopolistic” tortilla companies like Grupo Gruma and have enacted price controls that will only worsen the future supply picture.

Once the stage for easy pesos was set, the final catalyst that sparked the Mexican tortilla price explosion was the U.S. government’s boneheaded policy of subsidizing corn-based ethanol. Demand from dozens of new ethanol plants has stretched the U.S. corn market to its limit. High corn prices have attracted all excess supply away from international markets, causing a shortage in Mexico’s regular imports from the U.S.

Paper money inflation is not confined to Mexico. Loose U.S. monetary policies and ethanol subsidies are combining to form a future perfect storm in the price of basic food ingredients. Those holding their breath for imminent Fed rate cuts will probably have to hold it beyond this year’s corn harvest.

The average Mexican citizen facing spiraling food costs doesn’t seem to care about housing prices or rallies in the Mexican stock exchange. Will Americans be facing this situation at some point in the future?

The Global Economy Floats on a Sea of Paper Money

Over the past decade, a few billion new capitalists began their quest to achieve Western living standards. They will demand energy and industrial metals on an unprecedented scale, and the best way for investors to benefit from this trend is to own shares in the companies fulfilling this demand.

This capitalist revolution is well under way and nothing short of an economic meltdown will stop it. Just in case the economic machine that funds mortgage payments and all other manners of debt begins to sputter, central banks will slash interest rates yet again.

But unlike the 2001-2003 series of rate cuts, long-term rates are more likely to increase as CPI fears mount, causing demand for long-term bonds to dry up.

If that were to occur, the U.S. Federal Reserve would implement Chairman Bernanke’s well-outlined “unconventional monetary policies.” This would involve a new role for the Fed: buyer of last resort for bonds of any maturity. And lest you think the Fed could ever run out of money, check to see what institution guarantees the value of the “Federal Reserve notes” sitting in your wallet. If necessary, the Fed can use its ability to create an unlimited amount of this paper to keep the debt pyramid solvent.

If this scenario were to develop, the U.S. dollar would quickly be added to history’s long list of worthless paper currencies. Under the status quo, the U.S. dollar’s rate of decay will depend on public perception of inflation, and perceptions are likely to worsen after this year’s corn crop.

Thanks to corn-based ethanol subsidies, a huge portion of the country’s corn-derived food supply — everything from sweeteners in packaged foods to chicken and beef — will suffer from shortages and price increases. Much of this will be passed onto the consumers who can least afford it. So investors should expect the current momentum behind populist political movements to grow stronger. This will be bad for longer-maturity bonds and the overall stock market, but good for gold prices.

The global economy now floats on a sea of paper money. This grand monetary experiment has been in place for only a few decades — a mere tick in the clock of civilization. We know how this show ends, having seen previews in Weimar Germany and several banana republics.

Will the price of gold ultimately increase from its current $620 to $3,000 per ounce? I expect that it will. A better way to frame this large number is to flip the ratio from dollars per ounce to “ounce per dollars.”

Regards,

Dan Amoss, CFA
for The Daily Reckoning

P.S. Investors who hold gold will be very reluctant to sell it when dollar holders around the world anticipate the endgame of paper monetary systems. For its holders, gold will serve as a solid bridge on the journey from this monetary system to the next. Steady accumulation of gold-related investments remains a prudent strategy, and this month, I have a new gold stock to recommend to my Strategic Investment subscribers. See here for the full story:

Strategic Investment

Editor’s Note: Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored “big picture” trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.

by Bill Bonner

“Credit issues are there but they are contained.”

– Hank Paulson, March 6, 2007

You can take the temper of an era by looking to see what its brightest minds take up. Pythagoras applied himself to geometry. Alexander Fleming discovered penicillin. Wernher von Braun built rockets to blow up London.

But if St. Augustine were alive today, he’d probably be touting the benefits of globalized markets. Isaac Newton would be running a hedge fund in London. And Henri Poincare would be working for Goldman Sachs, calculating the return on a tranche of BBB-rate subprime debt.

Scientists and philosophers alike have turned their focus to the greatest challenge and opportunity of our time: Relieving other people of their money. We are voyeurs…gawkers at the merry and absurd world of money. And now comes the part that makes this sorry métier of ours worthwhile.

This week, traders at the big financial houses in the City and Wall Street were marking down their own paper. Merrill equity analysts, for example, cut their recommendations on Goldman, Lehman and Bear Stearns shares (as well as those of European banks Deutsche Bank and Credit Suisse Group) from ‘buy’ to ‘neutral.’

As for the bonds of the three biggest securities firms – they are judged by bond traders (many of whose paychecks come from these same big securities firms) at prices more suitable to junk bonds than to the masters of the universe. On Tuesday, Goldman astonished analysts with higher earnings than any had seen coming; still, investors sold off the stock.

The banana peel on which these august figures skidded was subprime mortgage lending. Looking closer, we see that the inside surface was slick with a special kind of mortgage, known institutionally as a ‘low documentation’ loan…and known colloquially as a ‘liar’s loan.’

As to their ability to pay (and perhaps even as to their name and address) lenders took the borrowers at their word. With no solid incomes to boast about, nor any real assets to wave as collateral before the lenders’ turned up noses, the poor borrowers had to fib a little. Yes, they had been employed as a bank president for more than a dozen years. Yes, they owned an oil refinery in central London and were mentioned, briefly, in Howard Hughes’ will. No, they called no man a creditor…and yes, they were only borrowing money to buy a house because they didn’t want to take any of their own capital out of the high-performance hedge funds in which it was earning 50% per year.

Any simpleton could see that ‘liars’ loans’ would be a disaster for someone. But it took a near meltdown in the mortgage market to bring the point home to the geniuses in the financial industry.

The entertainment began on February 7, when HSBC announced that it had fired its head of North American operations, after its bad debt – much of it from subprime ‘piggyback’ loans – rose to $6.8 billion.

And then it continued, when New Century Financial, the second biggest subprime lender in America (carrying $23 billion in debt), came crashing down. The stock fell from $66 to near zero…giving up 43% in just three days in February, and most of the rest when the NYSE halted trading last week.

“The banks also appear to have been caught unawares by the scope of New Century’s problems,” says an article in the New York Times. “ For instance, a week after the company said it would have to restate its financial statements for the first nine months of last year, Goldman Sachs extended to May 14 a credit line to New Century that was set to expire on Feb. 15.”

And what of the nation’s numero uno in the subprime market? According to the press reports, in 2006, Wells Fargo & Co. leaped ahead of Ameriquest Mortgage Co., and New Century Financial Corp. to become the biggest funder of subprime mortgages. And as of December, when other lenders were already in retreat, Wells Fargo was still charging ahead, increasing its lending to the least creditworthy buyers.

Subprime lending is like selling used cars in bad neighborhoods; it is not for those with delicated scruples or refined manners. Wells Fargo has been accused of ‘predatory lending’ – and that maybe so. But subprime lenders now look more like fools than knaves.

On one of the many websites that seems to have been set up for Wells Fargo customers to kvetch, we find this interesting thread:

Poster #1: “Check out this beauty at 2909 Allenhurst St. This property was purchased on September 30, 2005 for $264,000. However, due to the inability of the borrower to make payments, Wells Fargo foreclosed on these folks on January 29, 2007. Now the property is listed for sale for $225,000…”

Poster #2: “Multiply this outcome by the thousands and you can get the picture of how this speculative mania will end… Right now there are 100-150 NOD’s [notice of default] filed a week in Kern County; I predict that in a year we will have 200-250 NOD’s per week in Kern County. Credit is tightening, inventory is increasing and foreclosures are rising…the pain is only beginning.”

Poster #3: “The house is worth 125K at the most. Probably one of those late seventies shacks off Ashe.”

Poster #4: “The house was just sold on 1/29/07 $204,000.”

How much did Wells Fargo lose on this transaction? Twenty percent? Fifteen percent? How many of these banana peels could there be?

Even the smartest lenders – the world’s leading financial institutions, including Britain’s number one bank – were providing money to the subprime salesmen, all of them presumably aware that their collateral rested on white lies.

And so now they are all slipping and sliding…grabbing for something to hold onto.

Until only a few months ago, the constant welling up of house prices gave them some traction. When a sad-sack subprime buyer gave up and defaulted, the lenders, and the lenders to the lenders, and the lenders to the lenders to the lenders, could still tread confidently, secure in the knowledge that they could sell the shacks and get their money back – and more.

What they didn’t seem to realize was what seemed most obvious – that house prices wouldn’t go up forever. Indeed, some day they might even go down. And when they went down, lenders would have neither a strong borrower to make payments, nor decent collateral to sell, nor even a buyer with any money to sell it to.

What bothered New Century Financial was that the people they lent money to could not pay them back. What now bothers Goldman, Merrill and the rest of the smarty-pants businesses is no different. Their credits are going bad. All the way up the financial food chain, they applied the same ‘low documentation’ standards to the mortgage-backed securities business that the New Century applied to the mortgage itself.

Now, for readers who may be as unfamiliar with mortgage backed securities (MBSs) and collateralized debt obligations (CDOs) as we are, we supply the following elucidation of these two life-enhancing inventions: Imagine the entire mortgage market as a giant pig and the financial industry as a rendering plant. After the best lenders have taken the AAA++ hams and ribs, there remain many body parts you might show to your daughter only if you wanted to see her make a face and hear her say ‘eeewwww.’ In the mortgage industry, as in the slaughterhouses, those cuts do not get the ‘prime’ label. In lending, they are known as ‘subprime.’

The low-priced stuff is too disgusting for most people to put directly on the table, so the unidentified scraps are typically run through the grinder. Then, they are packaged into old-fashioned, pure pork mortgage-backed sausages. Even at this level, the investors never met the borrowers (and often not even the lenders) and were never privy to the particular lies that coaxed the animal into the abattoir in the first place. Nevertheless, the markets are familiar with these things; they know more or less what is in them…and have some slim idea of what they are worth.

But then the St. Augustines, the Newtons, and the Poincares of our time go to work. The tranches of meat are repackaged according to the latest scientific formulas – mixing the parts together ever so carefully so that they don’t go bad all at once. Then, they are resold as CDOs, either of the regular or synthetic variety. The whole is better than the sum of its parts, they claim.

For mysterious reasons, the rating agencies have agreed. And the buyers, with neither the time nor the competence to double-check the assumptions or carefully inspect the sausages Рtend to go along too. And thus it is that the cr̬me de la cr̬me of the financial industry finds itself in the same position as the subprime lenders themselves Рtaking the liars at their word.

The big difference is that the original liars – who bought the subprime houses with money they didn’t have – could leave as they came in. The CDO investors, on the other hand, had something to lose. They paid real money for the subprime debt. When they leave, they leave poorer than they came in.

But the way to make money in a gold rush, say the old-timers, is not to dig in the ground for it yourself, but rather to sell the miners picks and shovels. In the mad rush for profits of the 21st century, Goldman, Merrill, HSBC and the rest of them did a lot of both.

The trouble now is, the pick and shovel business may be turning down. No matter how many shovels Goldman may have sold in the boom, it is sure to sell fewer in the bust.

As for its own mining claims, a number of them seem to be going to the devil. Goldman’s own Global Alpha fund, the hedge fund where its own insider scientists dig for gold, lost 6% last year when the S&P actually was up over 15% and the average hedge fund was up 13%.

And now, the subprime mine seems played out. “What has been a credit concern seems to be morphing into a liquidity crunch for all parties involved,” wrote Morgan Stanley in its daily bulletin on subprime. Who are the parties? Morgan Stanley spelled it out: “HEL [home-equity loan] borrower, HEL originator – and finally – HEL trader/investors.”

Regards,

Bill Bonner
For The Daily Reckoning

P.S. In the upcoming Survival Report, we give a full expose of Goldman Sachs and its role in the current subprime housing fiasco. In addition to two other outstanding reports, this third report is included free as a special bonus for charter members who sign up now. For details, click here: The Survival Report

Editor’s Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).

In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount – just click on the link below:

Empire of Debt

by Kevin Kerr

Opportunities abound for investors in the energy market right now, just looking at what’s being set in motion globally. The end of the age of oil will not be a disaster if we are prepared for it as investors and consumers. Acceptance is the first step.

Aside from water, the world is most thirsty for oil. Since the last major oil crisis in the 1980s, there’s been tremendous population growth, with no less than one-third of that population beginning to industrialize their economies. Look at China, home to 1.3 billion people, and India, with more than another billion. Both these economies are growing fast, and they must have oil.

Then add the United States’s oil addiction to the mix, with our everlarger gas guzzlers and our seemingly insatiable desire for bigger and better, whether it’s cars, boats, houses, amusement parks, shopping malls, or whatever.

Combine this demand with dwindling global supply, the ongoing threat of terrorist attacks, the fact that there has not been a major oil find in more than 36 years, natural disasters such as last year’s hurricanes along the Gulf Coast, and continued geopolitical tensions, and don’t be surprised if oil reaches $150 a barrel, or more. How can you capitalize on this?

It’s always important to have vision, to see beyond the short-term outlook and predict what can and may happen in the future. It’s essential to know which seasonal and geopolitical factors will drive demand. Do your homework! Learn to decipher and understand industry reports such as the Energy Information Agency weekly inventory report.

By using spread trades and options in the energy markets, traders can maximize profit potential while limiting downside risk. (Spread trades are exactly what they sound like. The most common spreads are those between the different trading months, such as December/January spreads or, as we call them, DEC/JAN spreads. Basically, you are simply trying to trade a price differential between the months. There are many different types of spreads but this kind is the most common.)

Oil is the lifeblood that moves things, that keeps the whole world functioning and growing. In the last 100 years we have become very spoiled – we’ve been used to easily obtained, easily moved, and easily processed petroleum, crude oil, and natural gas. We have simply come to expect that they will be there forever, or at least for our lifetime. Oil, among other things, spurred the development of the internalcombustion engine, which does the work of a thousand people. Oil essentially constitutes a major workforce throughout the world.

This virtually invisible workforce has allowed the world’s population to grow to over 6 billion. Not only that, it has allowed us to plow millions of acres of land, to produce fertilizers, to transport people and goods, even to wage global wars and to set up global communication systems. Our dependence on oil, and energy as we know it, is similar to an addict’s powerful affliction. The world’s craving for oil is just as debilitating.

At this moment the United States doesn’t have an energy source that would be as easy to produce and transport as oil. Nuclear power can produce electricity, but the remaining rich uranium ore will last for decades, not for centuries. Renewable energy can probably never cover the current levels of global energy consumption or even U.S. consumption.

So what is a practical solution right now?

Recovery from oil addiction is possible, and the long-term, easy-to-reach answer may be in a fuel source that is right under our feet – coal. Coal is cheap and reliable and much cleaner-burning than it use to be. As the world goes through painful withdrawal from oil dependence, coal may help. It seems that the market feels this way, too: Coal prices have been soaring over the past year.

Clean coal technology (CCT) is employed when coal arriving at a power plant contains other by-products that need to be taken out before it can be used. A facility like this uses a number of processes to remove unwanted minerals, which makes the coal burn cleaner and more efficiently.

Coal has often been stereotyped as a dirty and less desirable product of the energy industry, but not anymore. As the world searches for energy solutions, coal is at the forefront, and new, clean-burning coal technology means it’s highly likely that coal will be around for some time to come.

It turns our turbines and runs our assembly lines; . . . it powers the Internet, our databases, and company networks. When we read in bed, turn on the air-conditioning, look at the nighttime skyline, it’s there.

And we take for granted that it will always be there, every time. But when more and more people, in more and more countries, start making that assumption, you have a situation. Right now, one in every three people doesn’t even have electricity. And already, our electrical grids are overtaxed and electricity demand is higher than it’s ever been.

What happens when the rest of China and India hop onto the power grid?

In China alone, electricity demand is 150 percent higher right now than it was when China first started to boom, back in 1980. Worldwide electricity demand is expected to explode by another 85 percent before the year 2020, faster than demand for any other kind of energy.

What happens when the world population hits 7 billion? How about 8 billion? Or 9 billion, as the United Nations is predicting? Hospitals without life-support machines. Grocery stores without refrigerators. Shopping malls, office towers, and neon gone dark. Printers and fax machines that don’t hum. Trains that don’t run, phones that don’t ring, computers that don’t blip or announce new e-mail. . . . because there is no e-mail; there is no Internet. The global grid is down. And where it’s still up and running, it’s pockmarked with dead zones that have made the whole network slow to a crawl. Even the electronic stock tickers on Wall Street have flickered out.

Without billions of dollars invested in new electricity resources right now, imagine brownouts, blackouts, shutdowns, and worse on a scale 10 times greater than anything we’re seeing today.

This all sounds scary and not quite real. It doesn’t have to be real if the biggest and most ambitious economies in the world kick in right now with several hundred billion dollars to jump-start a whole new era of electricity investing.

The good news is that the total $16 trillion headed for all the energy markets – including the $10 trillion that will go into electricity – is still just a fraction of the total global gross domestic product (GDP) – only about 1 percent. So making the investment is not only very possible, it’s nearly certain.

The electricity markets are still in their infancy in the commodities world. As with so many other up-and-coming opportunities, you just have to be ready to seize those chances when they come. Speaking of opportunities, alternative energy is another area investors are focusing on, and one of the biggest is solar power.

The idea of using the sun to solve the earth’s energy needs is hardly new; it’s been used since the dawn of time. What is new is the technology and research money that are breathing life into the industry. The rallying cry for quick and easy solutions to our nation’s oil addiction spurred immediate interest in alternative energy, from nuclear to ethanol. Solar power faces some challenges, to be sure, but there are some solid players who certainly bloom in this sector. Just add sunshine and a little ingenuity, and watch the profits grow.

Since the 1970s, the solar power industry has come a long way. We’ve reached a point where solar power is no longer a gimmicky, peculiar energy source; it’s now more of a necessity.

The solar energy industry has made enormous progress in the past 20 years, finding new solutions to the ongoing problems of high costs and massive regulatory barriers – but there are still roadblocks. Solar technology has become more affordable, due mainly to higher demand and the goal of eliminating dependence on foreign oil.

Manufacturing processes have been streamlined and continue to become more cost-efficient with the help of government subsidies, consumer rebates, and tax credits. As oil prices continue to increase exponentially, it seems inevitable that a convergence of the cost of conventional and alternative energy costs will occur. Many companies in the solar sector seem to be focused on the development of improved solar efficiency through broadbased applications that can be put to practical, immediate use.

Now, one thing that is very important to investors in any sector is the fact that every trade has flaws. In the case of solar power, there are several.

Although there is so much good news for solar power, there are challenges, too. For example, there’s the lack of silicon, which is needed for making solar panels. A silicon shortage has limited the supply of the panels and frustrated potential buyers. Orders take several months to complete, and prices, after years of floundering, have increased by as much as 15 percent.

The real winners are those companies that benefit from the lack of silicon, primarily producers of less efficient, yet available, thin-film solar panels. Of course, other beneficiaries include companies that have emerging technologies, such as plastic solar cells.

Worldwide, the solar market has exploded, growing by 40 percent annually in just the last five years. Germany and Japan alone use 39 percent and 30 percent, respectively, of the global solar panel stockpile. The United States is a distant third, at only 9 percent of the global solar panel supply, according to various energy information sites. California is likely to drive that stat much higher as demand grows exponentially in that state and others, too.

Kevin Kerr
For The Daily Reckoning
Original title: “Forecast: Partly Cloudy”

P.S In Outstanding Investments, we often write about the most profitable ways to play the global energy boom – and our readers have been quite pleased with the results. That’s why we’ve decided to package all of our commodity-related publications together in one easy package so you can effortlessly take advantage of the next leg of the massive commodity super boom.

For a very limited time, you can get what we are calling the “Resource Reserve” for a ridiculously low price. But act now – this offer is only open to a limited number of people…and spaces are filling up fast. Click here for details. Resource Reserve – Open to the Public Until April 1, 2007

Editor’s Note: Kevin Kerr is the editor of two highly successful and acclaimed financial advisory newsletters, Resource Trader Alert and Outstanding Investments. A veteran commodities trader, Kevin uses his irreplaceable experience to advise his readers on a variety of commodities investments on a daily basis. Widely considered one of the nation’s top commodities gurus, Kevin’s expert opinions are routinely featured in the country’s premier media outlets.

The above was taken from Kevin’s soon-to-be-released book, A Maniac Commodity Trader’s Guide to Making a Fortune. In the book, Kevin dispels the common myths and misconceptions about these markets, offering an insider’s view of what he calls “the last bastion of pure capitalism on Earth.” Whether you’re a novice or an experienced trader, Kevin’s down-to-earth, clear-cut guidance will make you more savvy, more confident, and more able to jump right in and grab those profit opportunities that are waiting for you. The book is available for pre-sale here:

A Maniac Commodity Trader’s Guide to Making a Fortune

Probably the greatest disappointment to a modern man over the age of 50 comes when he looks in the mirror.

We say that not as a man who has just had his vacation in a bathing suit, but as one who has spent the last couple of days reading the financial press. The two are alike in that every time you look, the picture seems to get worse.

A brief summary of the subprime industry’s business model: There is a market, lenders noticed, of people who cannot afford houses and do not qualify for the credit necessary to buy them. On the surface of it, lending money to these people does not seem like a business you would want to take up. But ‘subprime’ borrowers could be decent fish, the sharks reasoned, as long as they could make the mortgage payments. The quants did the math. The strategists looked ahead. Even if the occasional client couldn’t pay up, they had the rising housing market to lift the value of their collateral. And so, a new ‘go-go’ financial industry got going…and pretty soon, its hustlers and entrepreneurs – like the whiz kids of the dotcoms who preceded them – were driving Ferraris and drinking Chateau Petrus.

The Orange County (California) Register:

“For Kal Elsayed, a former executive at New Century Financial, a large lender based in Irvine, driving a red convertible Ferrari to work at a company that provided home loans to people with low incomes and weak credit might have appeared ostentatious, he now acknowledges. But, he says, that was nothing compared with the private jets that executives at other companies had.

“‘You just lost touch with reality after a while because that’s just how people were living,’ said Mr. Elsayed, 42, who spent nine years at New Century before leaving to start his own mortgage firm in 2005. ‘We made so much money you couldn’t believe it. And you didn’t have to do anything. You just had to show up.’”

It was this last line that caught our attention and triggered our disappointment. It reminded us how each generation of geniuses are later unmasked as frauds and fools. It reminded us too of what weak-minded simpletons we humans are; we are always falling for our own line of guff.

Modern Homo Sapiens Economicus believes in capitalism. He believes in it as he once believed in the Holy Trinity or the Virgin birth – as dogma. And so, he takes up its tenets and excesses without question or arriere pensees. And, he makes as big a mess of it as his ancestors did of the Crusades.

This is as true of the lumpen as it is of the masters of the universe.

Recall Henry Paulson’s soothing words:

“Credit issues are there, but they are contained,” the U.S. Treasury Secretary said to reporters in Tokyo during a four-day tour of Asia. The U.S. financial sector is healthy and most institutions won’t feel “a big impact.”

But a big impact is just what institutions feel – after they have flapped their wings and taken to the air. Typically, they come down with a thud.

The geniuses packaged, bought and sold subprime debt right until they heard the crashing noises. They believed the credits were good as long as homeowners could make their payments. And they saw no reason why homeowners wouldn’t be able to make their payments as long as they had jobs. That was their line of guff; and they believed it. In a world of full employment, there was no reason for the mortgages to go bad – in theory. But theories arise as needed when there is a sale to be made.

The theory was that low interest rates were giving a whole new group of borrowers access to credit. The reality was that, what made credit available to un-creditworthy borrowers, was the kind of corruption that wishful thinking hides, but that mirrors…and history…reveal.

“What drove the housing-led cycle was not as much the cost of credit,” notes Merrill Lynch’s David Rosenberg, “but rather the widespread availability of credit – irrespective of your FICO score [a measure of your ability to repay]…only a third of the parabolic run-up in the home price-to-rent ratio was due to low interest rates. The other two-thirds reflected other non-price influences, such as lax credit guidelines by the banks and mortgage brokers.”

Now, despite 4.6% unemployment and 4.7% yield on 10-year Treasury notes…the subprime lending business is crashing and burning. From Orange County comes news that the aforementioned New Century Financial is trading below $5 a share…a precipitous fall from its high of $66 in December of 2004. At today’s price, in theory, the Golden State lender must be the bargain of a century, with a dividend yield of 167%. But, again, the reality is different: The news report also tells us that the company may be forced into bankruptcy.

While the subprime lenders are being pulled from the wreckage, the superprime borrowers are still flying high. In theory, hedge funds charge extraordinary fees for extraordinary performance – 2% of capital and 20% of performance. For what? To return to the Greek alphabet, for helping investors get ‘alpha’ – a rate of return above and beyond ‘beta,’ which is what the general market produces.

Warren Buffett, probably the greatest investor who ever lived, says the whole idea is “grotesque.” In last week’s letter to shareholders, he explains that you could invest in his “hedge fund,” otherwise known as Berkshire Hathaway, and pay no management fees at all.

The compounded average annual gain of Berkshire Hathaway from 1965 to 2006 is 21.4%. What does the average hedge fund get? In 2006, hedge funds produced a 14% return, almost doubling the 7.6% of 2005 and better than the 10% they did in 2004. Over the longer run, hedge funds show an annual return of about 7%.

Mark Gilbert, summing up for Bloomberg News, concludes that hedge funds, “levy outsized fees on the pretense of generating tons of clever alpha, when they are really just seizing the beta available to anyone.”

In other words, in practice, the hedge fund managers, like the dotcom entrepreneurs and the subprime lenders, are not really geniuses at all. They make their money just by showing up…just like everyone else. And they get the same rate of return. Or worse.

Many funds and hedge funds jumped into Japan after that market went up 40% in 2005. The following year, 2006, was disappointing. The Nikkei Dow rose barely 4%. How did the hedge funds do? As Merryn Somerset Webb reported last week, “far from proving their ability to make absolute returns in any market conditions, [hedge funds] did particularly badly; they all fell between 5% and 20% over the year.”

Subprime lenders did not hedge the risk inherent in lending to weak borrowers. Instead, they sought it out and leveraged it up. Hedge funds seem to have done the same thing – reaching out a little too far in order to grab a few extra points of yield. Now, we wonder who owns the $23 billion of New Century Financial debt…and who owns the rest of the debt in the subprime area? We wonder too, who owned the $2.5 trillion worth of equity value that disappeared last week? Surely, there’s some more ‘big impact’ lurking out there…still waiting to hit someone.

We look in the mirror and hope it isn’t us.

Regards,

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 Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).

In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount – just click on the link below:

Empire of Debt

http://www.dailyreckoning.com/empireofdebt.html

Over the last decade the commodity markets have changed to the point that to some they may be unrecognizable. Since 1848, the open outcry and hand signal method of trading on commodity exchange floors was the only way to go. Enter electronic trading in the early 1990s, and soon the old auction method looked as if it were about to die any minute. Add the Internet and easier access to these markets by individuals, and it was bye-bye trading floor, hello computer screen.

We all know that didn’t happen, and I personally believe it won’t happen. But we can’t deny that the electronic era is here to stay.

Today’s trading methods aren’t your grandfather’s, and neither are today’s markets. The markets we see actively trading today may not be the only ones we will see trading five years down the road. We may see alternative energy commodities such as ethanol take off from their infancy. We may see markets like corn and sugar explode because of ethanol demand. We may see new contracts for such things as water. We’ve seen commodity exchange seat prices jump, and we’ve seen the world scramble for resources. The explosion in commodities and natural resources over the last few years has been remarkable. As a nearly 20-year veteran of these markets, I have never seen anything like it- and it’s showing little sign of slowing.

There are certain commodities that are staples of trading and most all investors should know these sectors and be very comfortable with them…one of them being, of course, gold.

“All That Glitters”- that’s what the old COMEX marketing line was. Back when I started trading, the COMEX was the top exchange in New York, the crème de la crème. The badge was green in color, and it took a lot of “green” to get one. At the time, a seat on the COMEX also was the most expensive seat on the New York exchanges, of which there were really four: the Coffee Sugar and Cocoa Exchange (CSCE), the New York Mercantile Exchange (NYMEX), the New York Cotton Exchange (NYCTN), and the Commodities Exchange (COMEX).

Chicago markets like the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) were viewed as being on an even higher plane, and most Chicago traders considered the New York markets to be second-class citizens. Now much of that has changed. But as I arrived on the scene, a pivotal shift was happening: As the NYMEX began to grow in stature, the COMEX became a bit more tarnished.

The Hunt brothers’ silver debacle, after their attempt to corner the world silver market in early 1980, drove many investors away from the metals, and some never returned. Today, however, the metals have come full circle, and silver, which for most of my career traded in the $5 to $7 range, is now busting out to new highs almost monthly. For many years, gold was simply a hedge against inflation, but not anymore; today, the shiny yellow metal is being sought as a flight to a quality instrument but also for its uses in jewelry on a large scale. The new gold exchange-traded funds also have helped to drive the price of gold higher, as these new instruments are backed by physical gold.

E-gold is another phenomenon that is not just fantasy anymore. Gone are the ideas of returning to barter using gold nuggets. Today’s modern commerce allows the exchange of electronic gold credits between parties all around the world. This virtually eliminates currency risk and opts for one currency: gold!

The metals markets can be very volatile, and one strategy for capitalizing on the long-term rise in gold is to use options- specifically, long-dated gold options that may seem very far out of the money. FYI: An option is the right, but not the obligation, to buy or sell something (called the underlying- in this case, gold futures contracts) at a specific price, before the expiration date of the option. A long-dated option is one that expires a long time into the future. For example, as I write this, gold is trading in the low $600s but had been over $700 an ounce. It’s quite possible gold could surge to $1,000 an ounce, and any traders worth their badges would want to be in on it! So to play this right now (with gold at $623), we would add the $950 call options.

They would be considered quite far out of the money. There’s one of those pesky trader terms again. Let me clarify. In dealing with options, when you buy an option and the current futures price is below your option’s price, it is called buying an out-of-the money option. When the futures trade up to the price of your option, it is called an at-the-money option, and when the futures price is above your option’s price, it is called an in-the-money option. As I was saying, a $950 call option would be considered way out of the money if gold was currently trading at $623, but all that could change if gold rallies to new highs.

Meanwhile, by buying gold options, my risk potential is limited to the premium (price) I pay; I can’t lose any more than I initially invested. It is one of the safest ways to invest in gold.

On to silver…

For years the silver market has languished in a narrow range with little momentum and not much of a bright future. Unlike its golden counterpart, silver has been more like the redheaded stepchild of precious metals. Not anymore.

This often maligned metal is up a whopping 60 percent since the beginning of 2005, and so far 2006 is looking good, too. There are many ways to play silver, just as there are for gold: silver bars, ingots, coins, jewelry, certificates, stocks, futures, and options. All have advantages and disadvantages, but the one we want to add to our portfolio is silver options.

Silver closed at its highest level in more than 22 years recently on hopeful expectations that the Securities and Exchange Commission would soon approve a silver-backed exchange-traded fund. This silver ETF is similar to the gold futures-based funds, streetTracks Gold and IShares Comex Gold Trust. According to reports, investors hold more than 14 million ounces of gold in the ETFs- that’s significant because it’s equivalent to about a fourth of last year’s worldwide supplies.

In 2006, silver had an incredible performance in my portfolios and those of my readers. The launch of the silver ETF drove silver prices up several cents, and seemingly out-of-the-money options were tripling and quadrupling in price. In less than a two-month period, our positions were returning unheard-of 400 percent profits and went even beyond that.

Regards,

Kevin Kerr

for The Daily Reckoning

Editor’s Note: Kevin Kerr is the editor of two highly successful and acclaimed financial advisory newsletters, Resource Trader Alert and Outstanding Investments. A veteran commodities trader, Kevin uses his irreplaceable experience to advise his readers on a variety of commodities investments on a daily basis. Widely considered one of the nation’s top commodities gurus, Kevin’s expert opinions are routinely featured in the country’s premier media outlets.

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THE PERFECT STORM IN POWER

by Chris Mayer

The Perfect Storm dramatized the events surrounding a powerful nor’easter that raged over the Atlantic Ocean in 1991. The storm was the product of some fluky weather patterns, all of which converged to create a monster of a storm. The movie focused on the ill-fated travails of a small fishing boat, the Andrea Gail of Gloucester, Mass., which was lost at sea. It was a good movie, I thought. You could almost smell the fish and salty sea air and feel its cold dampness on your skin.

Probably in part due to the success of that film, we commonly use the phrase “perfect storm” these days to describe a combination of events which, taken individually, would have been far less powerful.

The idea of a “perfect storm” comes to mind when I think about the world’s need for new electrical power grids.

I recently wrote to you, dear reader, about the pressing issues facing the North American power grid. Blackouts already occur about once every four months on average in the U.S. And that includes only those blackouts that affect at least half a million homes.

Of course, it’s more than just a problem for those of us in North America. Power shortages exist in markets all over the world. That’s one of the things that make this so fascinating – and which bring to mind the idea of a perfect storm.

If it were just the U.S. and Canada, perhaps that would not be such a powerful investment theme. But it’s the combination with other parts of the world that give it an out-sized feel. Just adding China alone to the mix makes quite a difference.

I recently finished a book titled From Wall Street to the Great Wall, which further brings home this point. “Electrical power shortages are chronic today” in China, the authors note. “Blackouts are not uncommon, and manufacturing is affected directly.”

Later, the authors quote a story from the Guardian: “China is on the biggest power plant building spree the world has ever seen.” Hydroelectric dams, coal-fired generators and nuclear facilities sprout like weeds throughout China. “The equivalent of Britain’s entire electrical output is being added to the capacity of the country’s national grid every two years.”

Really, the power story is only part of a bigger thread. The more you look into this sort of thing, the more you find that it is about more than just power (or just water, for that matter). It’s a combination of all of these things. What we’re talking about is infrastructure. Admittedly, infrastructure is an ugly four-syllable word that leaves a lot of room for interpretation. As with pornography, you know it when you see it.

India, often paired up with China in these kinds of stories, has its own infrastructure problems. Wandering cows in the middle of pockmarked roads is only one of them. So notes The Wall Street Journal: “The nation’s capital is bedeviled by the same sort of cramped airports, rough roads and frequent power outages that recall the darker days (often literally) of China’s own economic opening.”

These are the headline cases. At the margins, though, you see similar trends in smaller emerging markets. All of it is more fuel for the perfect storm. Take a look at Africa.

There is an old joke told in many parts of Africa. It goes like this: “What did we do before we used candles?” Answer: “We had electricity.” War, poor management and under-investment have done their usual thing. And while the infrastructure of Africa crumbles, the population has tripled since the 1960s.

Investment dollars, though, are trickling back to Africa. There is the promise, for example, of the great Congo River. Harnessed, it could generate over 40,000 megawatts of electricity. That’s more than all of what South Africa produces today. Given a decent power station and linked to a modern power grid, the Congo River could supply power Africa needs for a long time.

Congo is typical of much of Africa. At Inga, Congo, there are two hydropower stations. The more modern one has eight hydroelectric turbines. However, years of neglect have left only three working. The Dark Continent – a term used originally to describe unexplored Africa – truly earns its name.

China has taken a big interest in Africa in its quest for natural resources – in particular, oil. The Chinese have already committed $10 billion in infrastructure projects. They’ve already built roads, railways, ports and more in Africa. China’s approach to Africa is a pragmatic one.

When the dollars don’t come from China, the World Bank or other places abroad, they come from within. For example, in South Africa, investment in infrastructure is a top priority. The government plans to spend $49 billion on roads, ports and power plants over the next three years.

This is an admittedly brief look at Africa. I could also tell you similar stories about the Middle East. Or I could talk about Southeast Asia (in particular, Vietnam and the Philippines). All of them plan to raise, or have raised, billions and billions of dollars for building the basics – things like power grids. It’s all part of the perfect storm I see shaping up in the world’s electrical power systems.

Regards,

Chris Mayer
for The Daily Reckoning

Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital and Crisis – formerly the Fleet Street Letter.

by Bill Bonner
“Behind every great fortune lies a crime.”

-Balzac
You can tell a leopard by its spots. But can you tell a boom by its fattest cats?

Maybe.

But, first, how do cats get fat?
It is not the goodwill of the baker that puts bread on a man’s table. And thank god. Otherwise, we’d all go hungry. Nor does the busboy bus for the benefit of mankind. Instead, everyone schleps, humps, sweats and toils for reasons of his own.
This insight – that people can pursue their own interests, and in so doing improve the lot of everyone – is the central insight of modern economists, at least those who aren’t idiots. The theory is simple enough; a man bakes bread not to put bread on others’ table, but to put it on his own. That others have bread to eat too is merely the happy consequence of a virtuous system. Likewise, the electrician doesn’t fix your wiring because he likes to see sparks fly. He has to earn a living too, and he does it by providing something useful to others.
The symmetry of it is elegant. The morality of it is appealing. Do unto others…and they will do unto you. And the more you do for others…the more you can expect them to do for you. That is why a properly functioning economy does seem to deliver something close to rough justice. Henry Ford brought the benefits of automobile transportation to the masses. He deserved to make a lot of money. Andrew Carnegie provided the nation with steel. John D. Rockefeller rolled up and rationalized an early market in oil. Who can say these tycoons of yesteryear did not deserve what they got?
Just look along the ‘Gold Coast’ of Connecticut. By the early 20th century, you could find the mansions built by the kings of industry and commerce of the period. Greenwich was home to the Simmons family, who made a fortune in mattresses…the Phelps Stokes family, who made their money in copper products…the Milbanks of Borden Condensed Milk…and ‘Sugar King’ Henry O. Havemeyer. Their grand houses were testament to their grand contributions; they were the people who built the wealth of America.
The rich got their money honestly back then…or, at least most of it. They put their family names on their products and spent their loot grandly. Silk shirts, top hats, spats…great limousines with chauffeurs…grand balls with orchestras…and servants dressed in proper outfits.
But now, what’s this? A new bunch of kings have taken its place in Greenwich, dressed in perma-pressed khaki pants with blue, open-collared shirts. They are richer and busier than any group of bees the honey-pot nation has every produced. Still, don’t bother to look for their last names on your refrigerator…or on your armchair…or even on your liquor bottles.
Paul Tudor Jones, who lives in a house in Greenwich that resembles the mansion in ‘Gone with the Wind’, is a very rich man. But what did he do for the money? He is not a king of industry. He does not bring milk to the masses; nor does he provide copper pipes for their water systems…nor mattresses to rest their weary bones. Mr. Jones is a Bubble King, who manages a $15 billion hedge fund.
In another little town favored by the new moneyed classes, Norwalk, the granite mansion of steamship magnate and head of U.S. Steel, James Augustus Farrell, has fallen into the hands of another Bubble King – Graham Capital Management, a hedge fund with $5 billion in assets and only 150 employees.
Graham’s chief financial officer lives on the other side of Long Island Sound and is said to commute to work by boat. We wonder why. At this point in the credit cycle we are convinced that bubble kings can walk on water!
Last week we argued that the present boom is a ‘fraud.’ This week, we look at those whom the fraud is rewarding so generously. If they are so richly paid, says the theory of modern capitalism, they must richly provide. But what?
Take Lloyd Blankfein. The Goldman Sachs man took the wheel at the firm after Hank Paulsen went on to greater glory at the Treasury Department. In the six months from the time he took the job until the end of the year, he is reported to have earned $53.4 million. Let’s see, that is about $9 million per month…nearly $2 million per week…or about $400,000 every working day.
And here…our eyes roll up to heaven as we wonder: What hath this man done? This is where the theory of meritocratic markets begins to pinch the common man like a starched shirt at a summer wedding. He’s sure it’s what he wants to wear; but he’s beginning to get uncomfortable in it. There is no better system than free and unfettered capitalism, he tells himself. He loathes the thought of mobs at Mr. Blankfein’s door…and thinks he is clever enough to resist the meddlers who want to put a limit on how much a man can earn. Still, he senses that there is something not quite right.
How is it that – in a free market system, where people are supposed to be rewarded according to how much they provide to others – today’s biggest prizes go to those who provide so little? Mr. Jenkins and Mr. Blankfein do not add in any appreciable way to the world’s wealth. Instead, they merely move it around – from middle and lower class taxpayers to the super-rich…from householders to speculators…and, by loading up the world with debt, from the future to the present.
The answer is to be found in the details of modern finance.
Since 1995, the U.S. money supply has risen at about 10% per annum. The world’s supply of gold, meanwhile, has risen at only about 2% per year. And the world’s supply of goods and services only about 3%. A free market presumes that money itself is an honest measure. Otherwise, all the “information” that free prices give is distorted and untrustworthy.
“The introduction of a non-market driven money controller into the financial system invalidates the assumptions on which free-market economic theory is based,” writes Martin Hutchinson. “In 1929-32, as Milton Friedman and Anna Schwarz demonstrated in their ‘Monetary History of the United States’ that non-market player, the Federal Reserve system, kept money too tight and precipitated a depression of a duration and severity that should, under the classical theory have been impossible.”
Central authorities have kept money too loose, deceived a whole generation, and redistributed more wealth than ever in history. Like a cosmetic surgeon moving fat around, they’ve fashioned a financial world so lumpy and lop-sided, its own mother wouldn’t recognize it.
Hutchinson adds:
“Lax monetary policy has continued for far longer than would normally have been possible, fully 12 years, a period of monetary ease and low real interest rates entirely without precedent. For more than a decade price signals have been distorted and resources have flowed in artificial directions….
“Globalization and the greater ease of outsourcing have kept wages down at the bottom of the scale in the [United States] and Europe (an effect which excessively lax immigration policy has compounded.) However at the top of the scale those able to benefit from IPOs, those with excessively large homes, the managers of hedge funds and private equity funds and above all the gatekeepers such as Goldman Sachs, who control access to the overwhelming flood of liquidity, have all benefited far more than they should have in a well-functioning economic system…

“The [United States] and world economic system [have] been distorted in these people’s favor for more than a decade, to the excessive benefit of their net worth. They have enjoyed a bubbling bull market for twelve years, and the wealth of the world has been artificially redistributed into their pockets. They have come to expect such benefits; the Goldman Sachs participation in the Initial Public Offering for the Industrial and Commercial Bank of China, in which the firm and its partners, mostly the latter individually, made a $6 billion profit due entirely to its insider position in the world financial markets, might have landed them in jail for insider trading in a more stringent environment but in this market only further fattened their bonus pool.”
Neither central bankers nor bank robbers create wealth. They merely redistribute it.
The mob idolizes holdup men; then, often, it lynches them. What they will do to the central bankers and their accomplices in the financial industry, we wait to find out.
Regards,
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 Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).

In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount – just click on the link below:
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NOT SO BENIGN CONSPIRACIES

by Justice Litle

“You could almost call it a benign conspiracy.”

– Chet Currier, Bloomberg columnist

Hard to believe it’s already December. What a year it has been… and 2007 will have even more in store.

The broad market appears to be firing on all cylinders. About the only thing getting sent to the wood shed is the U.S. dollar.

The action in the greenback looks exceptionally ugly. Yet if you step back and look at a monthly chart of the U.S. dollar index, we haven’t even broken the December 2004 lows.

There is more to come… much more to come. As Jesse Livermore, the greatest speculator of all time, once said: “The speculator’s greatest and truest ally is underlying conditions.” That about sums it up when it comes to the dollar — and gold.

We’ve laid out the macro case from multiple angles over the past year or two, most recently in our summation of the debt liquidation trade. Our own Addison Wiggin, has also gotten a few words in on the subject. His book, The Demise of the Dollar, is seeing a surge of renewed interest along with the greenback’s free fall. You can check it out here:

http://www.isecureonline.com/Reports/AFP/Demise

Bloomberg columnist Chet Currier thinks equities are getting a boost from the lack of appealing alternatives – a tongue-in-cheek “benign conspiracy” of sorts. In his piece, entitled “Costly Bonds, Real Estate Make Stocks Look Good,” Currier observes:

“Yields on government bonds are just plain miserly. Ditto for corporate bonds all up and down the quality scale… Yields offered by money market mutual funds and similar short-term vehicles have flattened since the Federal Reserve stopped increasing its target rate… the housing market is undergoing a much-discussed shakeout in many parts of the country.”

Currier goes on to note the “sloshing sea of cash” that is desperate to earn a return, forcing investors to bid up everything in sight.

Meanwhile, private equity players are busy privatizing everything in sight. Raymond James strategist Jeff Saut reports, “Almost 2% of the NYSE’s entire market capitalization has been taken private… since the beginning of this year.”

Meanwhile Ben Bernanke, the warm and fuzzy Fed chair, continues to blame the “global savings glut” for this foamy tide that has lifted all boats.

One of Gentle Ben’s key directives, I suspect, is looking out for his friends. I may have shared the following excerpt with you before; even if so, it is worth sharing again. Consider this intriguing observation from portfolio manager Chris Dialynas of PIMCO:

“The Clinton and Bush administrations, as well as the Greenspan Fed, have relied upon many internal and external advisers. Without doubt, most of these advisers are of Ivy League vintage. It is particularly noteworthy to understand that the endowments of most of those universities – endowments that substantially accrue to the benefit of the respective professors – are primarily invested in very high-risk assets and high-risk strategies (as are numerous other investors in their quest for high returns in a low interest rate world). It is, consequently, of little surprise that policy advice has tended to aggressive stimulus. A disciplined, ‘take-your- medicine/rebalance-the-economy’ set of policies would most likely be detrimental to the endowments of many of this country’s leading educational institutions. As long as these institutions maintain high-risk portfolios, the policy advice from the ivory towers will be highly stimulative based upon new, bizarre economic ideas. The global imbalances will grow.”

“Professor Bernanke is a member of this fraternity… There is an extraordinary challenge for a very high-quality person. My concern is his presumed pro-reflationary bias.”

An extraordinary challenge, indeed. So challenging, in fact, that it must be asked: Why “take the medicine” at all, when one can simply wade further into the soup instead?

This is certainly the best choice from a short-term utilitarian perspective: It maximizes the distribution of happiness for an extended period of time. Look at it from Gentle Ben’s point of view, and backdoor reflation is the way to go. Your friends are happy… Wall Street is happy… the president is happy… trading partners looking a bit peaked, but are happy nonetheless… no one gets left out except those cussed Austrian types. (And there’s no satisfying them anyway, right?)

High-quality person that he is, Bernanke has chosen to be a stand-up guy and keep the taps flowing for his friends. As I type these words, and as you read them, “cash” is being turned into “trash” at a steady pace. The smart money is buying with abandon because it knows the paper bits floating around today will be worth less than the paper bits floating around tomorrow.

How long can this go on? No one really knows. It’s sort of like a game of musical chairs. As long as a veneer of psychological stability is maintained – i.e., as long as cash doesn’t become trash too quickly – we could continue to see an upward trend in nominal values, even as real values stall out, or even decline.

Sooner or later, gold is going to break its 1980 highs in nominal terms. (This could easily happen in 2007.) After that, it will break its 1980 highs in inflation-adjusted terms — which will prove a much more noteworthy feat.

It’s always been sort of assumed that the conditions in which gold does this would be very ugly. Equity markets will have crashed, all Hades will have broken loose, and so on. That could certainly still be the case.

But it could also be that the Dow marches steadily higher along with gold, calm as a flat and glassy sea; if the fiction of prosperity is maintained, investors might be content to keep riding the merry-go-round, smiling like mildly sedated children.

In this scenario, everyone stays happy except the poor man in the street, who doesn’t have enough paper asset holdings to cancel out the steady rise in day-to-day living expenses. A slow debasement of the currency, to the benefit of paper asset holders, is thus a rather ingenious way to rob hundreds of millions of unaware citizens. Not all at once, of course, but in dribs and drabs… a little bit at a time.

Currier’s “benign conspiracy” is perhaps not so benign after all.

Since we’re laying on the quotes this week, here is one more from Aldous Huxley, author of the dystopian classic Brave New World. The quote is twice as old as I am, but could have been written yesterday:

“There is, of course, no reason why the new totalitarians should resemble the old. Government by clubs and firing squads, by artificial famine, mass imprisonment and mass deportation, is not only inhumane (nobody cares much about that nowadays), it is demonstrably inefficient and in an age of advanced technology, inefficiency is the sin against the Holy Ghost. A really efficient totalitarian state would be one in which the all-powerful executive of political bosses and their army of managers control a population of slaves who do not have to be coerced, because they love their servitude. To make them love it is the task assigned, in present-day totalitarian states, to ministries of propaganda, newspaper editors and schoolteachers… The most important Manhattan projects of the future will be vast government-sponsored enquiries into what the politicians and the participating scientists will call ‘the problem of happiness’ — in other words, the problem of making people love their servitude.”

The problem of happiness. Hmmm. Sound familiar? Not the most pleasant thought, I know. The world can be a depressing place at times.

But in spite of all the chicanery and deceit, there is much to be joyful for and much to be grateful for. If you see all this madness as a game – a game you are forced to play, but a game nonetheless – it becomes easier to take things less seriously. Best of all, with a little skill and determination, it is a game you can win.

Regards,

Justice Litle

for The Daily Reckoning

Editor’s Note: Justice Litle is an editor of Outstanding Investments, ranked number one by Hulbert’s Financial Digest for total return performance over the past five years. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall).

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NO REFUGE IN THE HERD

by Chris Mayer

My 4-year-old daughter heard the Rolling Stones song “You Can’t Always

Get What You Want.” To which she added, “This song is a truth I already know.”

Yes, we all learn pretty fast that we can’t always get what we want. And most of the time, bargains are hard to find. Like now. In times like this, I like to look back.

Investors, as with practitioners of other trades, are guided by precedent.

And so I spend a good bit of time poring over old books and looking over nuggets of market history, like a geologist picking up bits of rock. In those layers of sediment lie answers.

In this history, you will find ballast for those times when the rest of the market seems to go nuts. The historical record reminds us that common sense ultimately prevails. Herds, as a rule, make for poor investors.

Let’s look at the stock market of the 1960s, a maddening maelstrom of a market. All in all, it was not so different from the raging tech bubble of the late 1990s.

National Student Marketing was the poster child of the era. Here was a company designed to capture the “youth market.” The company bought everything and anything that might aid it in this quest. It owned youth- oriented travel agencies and insurance companies, college ring makers, college mug manufacturers and more. At its great height, it was selling for 150 times earnings.

Yet look who owned National Student Marketing. Bankers Trust and Morgan Guaranty, as well as General Electric’s pension fund. The endowments at Harvard, Cornell and the University of Chicago.

Yes, the old money of banks, pension funds and endowments. These are the people to whom the uninitiated turn for trusted advice. These are the people who are supposed to protect and grow their clients’ wealth.

In 1970, National Student Marketing went from $36 to $1. There were many others just like it.

Adam Smith (the pseudonym of George Goodman, best-selling author of The Money Game) hatched an unusual idea for an investment conference in 1970. Instead of the usual fare in which speakers talk about their successes and favorite ideas, Smith thought it might be good to have something of a public confessional.

His would be a conference at which people talk about their mistakes and misdeeds. Smith thought this would be good for the confessors and extremely instructive for the audience. Especially after the go-go market of the 1960s met its inevitable bad end.

David Babson, our protagonist, was one of those invited to speak at Smith’s conference. Babson, then turning 60, ran the sixth-biggest investment counseling business in the country at the time.

A little background on Babson sets the stage. He started his firm in 1940. He was bullish then. Babson recommended buying growth stocks, a move that made him a radical in those days when the memories of the Great Depression were still fresh. He bought all the right stocks, it seems — 3M, Honeywell, Merck, Pfizer, Corning Glass and more.

By the 1960s, though, Babson was no longer bullish. The feisty pipe-smoking New Englander was blunt and outspoken in chastising his peers for behaving like tape-watching speculators. He was a trenchant critic of the market at the time, which was a swirling stew of gimmicky malfeasance and excessive speculation. Babson blasted his peers for “outright gambling with other people’s money,” and he called the stock market a “national craps game.”

Just as Babson found himself out of step with the 1940s, so he found himself out of step again in the 1960s.

As Smith’s unusual conference got under way, Smith thought it was going pretty well, as intended. Then he tapped Babson for comments. He took the stage and addressed the crowd. Smith asked if the blame should go to the professionals for the ’60s bubble. Babson said yes, unequivocally, in so many words. “What should be done about this?” Smith asked.

And that’s when Babson, peering over his glasses, gazing down at the audience, delivered his knockout blow: “Some of you should leave this business,” he said.

Smith reports nervous laughter among the attendees. Then Babson practically named names and launched into an accusatory tongue-lashing, lambasting the folly and incompetence of his peers. Smith finally stopped him, but the conference had, as Smith reports, “taken a sour turn.” The audience sat in stunned silence.

Babson could say what he did because he didn’t own any of the nonsense stocks. He also solidified his status as an investment folk hero for his courage and independence. Not to mention the gratitude of his clients, who escaped the 1960s with their money still intact.

The current surging market surely will provide sins for future confessionals – every market does. After all, what investment adviser could possibly justify putting his clients’ hard-earned money into something as unsound as Research In Motion? The maker of the BlackBerry device posts slowing growth rates, faces numerous competitors and trades for more than 10 times sales and 60 times trailing earnings.

Research in Motion is of a type that is fairly common in the thin air of speculation these days. Look at Google, at 16 times sales and 62 times trailing earnings, or the NYSE, at 10 times sales and 119 times trailing earnings.

Yet these stocks find votaries among the pros. Look at who owns them. All the big houses – Fidelity, Barclays, Wellington, banks and trusts of various types. What are their investors paying them for?

So far, these stocks keep going up. In the latter part of the year, they rallied sharply, as did the market as whole. One day the caffeine will wear off, and with it the temporary illusion that these stocks are worth these prices. It seems only a matter of time.

Markets, though, are notoriously hard to read. People see what they want to see. Bulls will find reasons why these stocks will go higher. Bears will find reasons for them to go lower. The seldom-admitted truth is that most of the time, the market exists in some indeterminate state, like the muddled cherry of a whisky sour.

I think the main lesson from Babson is that you cannot trust consensus. You cannot rely on the “Establishment.” You can’t find refuge in the herd. And you must resist the urge to join the crowd. “Passion of the moment,” as writer J. P. Donleavy observed, “a disaster over the years.”

Babson’s firm, by the way, still lives on. Recently, it published a letter describing five essential truths the firm follows, laid out by its founder years ago. They are:

1. Markets are unpredictable and ill-suited to forecasts.

2. Long-term fundamentals are key.

3. Investor emotion leads to volatility.

4. Valuation discipline should guide investment selection.

5. Perspective and patience are rewarded.

That’s not a bad set of self-explanatory truths. They are not sexy, but the best investment advice seldom is. Investors would do well to remember them – and remember Babson -when considering whether or not they should plunge in on the hot stocks of the day.

Regards,

Chris Mayer

for The Daily Reckoning

Editor’s Note: Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital and Crisis – formerly the Fleet Street Letter.

The above essay has been adapted from Chris’ latest issue of Capital and Crisis. You can read more here:

Forget Oil! What’s Next?

http://www.isecureonline.com/Reports/FST/EFSTGA18

THE DISMAL HISTORY OF PHONY MONEY

by Addison Wiggin

History has shown that money – not counterfeit, but official money printed by the government – has been known to lose value and become virtually worthless. Examples include Russian rubles from pre-Revolution days, 50-million marks from 1920s Germany, and Cuban pesos from pre-Castro days. In all of these cases, jarring political and economic change destroyed currency values – suddenly, completely, and permanently.

What kinds of events could do the same thing to the U.S. dollar, and what can you do today to position yourself strategically? The potential fall of the dollar is good news if you know what steps to take today. We’re not as insulated as many Americans believe. In the 1930s, 20 percent of all U.S. banks went broke and 15 percent of life savings went up in smoke. After the emergency measures put into effect by President Franklin D. Roosevelt through the Emergency Banking Relief Act of 1933, confidence was restored with another piece of legislation: the 1933 Glass-Steagall Act. This bill created the Federal Deposit Insurance Corporation (FDIC), insuring all U.S. bank deposits against loss.

The severity of the growing situation had been seen well in advance. The financial newspaper Barron’s, established in 1921, editorialized in 1933 that: “Since early December, Washington had known that a major banking and financial crisis was probably inevitable. It was merely a question of where the first break would come and the manner of its coming.”

Two weeks earlier, the same column cautioned its readers that when the dollar begins to lose value, this leads to a series of “flights” – from property into bank deposits, then from deposits into currency, and finally from currency into gold.

We can apply these astute observations from 1933 to today’s currency situation. The government, anticipating a flight from currency into gold, had already made hoarding gold or even owning it illegal. The second step – insuring accounts in federal banks – helped to calm down the mood. By preventing the panic, currency stabilized. But in those times, we were still on the gold standard. The currency in circulation was, in fact, backed by something. Remember, that riverboat gambler who keeps asking for ever-higher markers will eventually run out of credit. At some point the casino boss realizes that his ability to repay is questionable. Maybe those markers are just a heap of IOUs that can never be cashed in.

In the 1930s, the causes of the Great Depression were complex but related to a series of obvious abuses in monetary, financial, and banking policies. History has simplified the issue by blaming the Depression on the stock market crash (which takes us back to the explanation that “wet sidewalks cause rain”). The stock market crash, one of many symptoms of policies run amok, has lessons for modern times. The unbridled printing of money – expansion of the “IOU economy” – is good news for those who recognize the potential for gold.

We hear experts on TV and in the print media shrugging off the deficit problems. “Our economy is strong and getting stronger” is the mantra of those with a vested interest in keeping dollars flowing: Wall Street brokers and analysts, for example. But we cannot ignore the facts. The federal deficit is growing by more than $40 billion per month. It is not realistic to point to this economy and say it’s doing just fine.

Gold is the beneficiary of reckless monetary policies and the War on Terror. Check the average value of an ounce of gold over the past decade. It has been rising steadily since the end of 2001. The cause of this change in gold’s price may be attributed at least partly to the attack on the World Trade Center. But it reflects equally on the Fed’s monetary policies and spiraling debt-based economic recovery. During the same period that gold prices have begun to rise, we should also take a look at the trend in money in circulation.

This is troubling for the dollar but – again – great news for gold. Remember what the world economic and political situation was like in the early 1970s: a weakening dollar, easy money, and international unrest. Sound familiar? We’re back in the same combination of circumstances that were present when gold prices went from $35 to over $800 per ounce.

The numbers prove that gold is going to be the investment of the future. World mining in gold averages 80 million ounces per year, but demand has been running at 110 million ounces. So if central banks want to hold the value of gold steady, at least 30 million ounces per year must be sold into the market. This creates a squeeze. As the dollar weakens, central banks will want to increase their holdings in gold bullion, not sell it off.

This is why gold’s price has started to rise and must continue to rise into the future. As long as that demand grows – and it will rise as the dollar’s value continues falling – the price of gold simply has to reflect the forces of supply and demand.

But, you might ask, why do central banks want to hold down the value of gold? We have to recognize how this whole money game works. Most world currencies are off the gold standard, following the U.S. example. So as gold’s value rises, it competes with each country’s currency. Of course, the trend toward weakening currencies and the continuing demand for gold mean that the growth in gold’s value could continue strongly for many years to come.

When the United States removed its currency from the gold standard, it seemed to make economic sense at the time. President Nixon saw this as the solution to a range of economic problems and, combined with wage and price freezes, printing as much money as desired looked like a good idea. Unfortunately, most of the world’s currencies followed suit. The world economy now runs primarily on a fiat money system.

Fiat money is so-called because it is not backed by any tangible asset such as gold, silver, or even seashells. The issuing government has decreed by fiat that “this money is a legal exchange medium, and it is worth what we say.” So lacking a gold backing or backing of some other precious metal, what gives the currency value? Is there a special reserve somewhere? No. Some economists have tried to explain away the problems of fiat money by pointing to the vast wealth of the United States in terms of productivity, natural resources, and land. But even if those assets are counted, they’re not liquid. They’re not part of the system of exchange. We have to deal with the fact that fiat money holds its value only as long as the people using that money continue to believe it has value – and as long as they continue to find people who will accept the currency in exchange for goods and services. The value of fiat money relies on confidence and expectation. So as we continue to increase twin deficit bubbles and as long as consumer debt keeps rising, our fiat money will eventually lose value. Gold, in comparison, has tangible value based on real market forces of supply and demand.

The short-term effect of converting from the gold standard to fiat money has been widespread prosperity. So the overall impression is that U.S. monetary policy has created and sustained this prosperity.

Why abandon the dollar when times are so good? This is where the great monetary trap is found. If we study the many economic bubbles in effect today, we know we eventually have to face up to the excesses, and that a big correction will occur. That means the dollar will fall and gold’s value will rise as a direct result.

The sad lesson of economic history will be that when the gold standard is abandoned, and when governments can print too much money, they will. That tendency is a disaster for any economic system, because excess money in circulation (too much debt, in other words) only encourages consumer behavior mirroring that policy.

Thus, we find ourselves in record-high levels of credit card debt, refinanced mortgages, and personal bankruptcies – all connected to that supposed prosperity based on printing far too much currency: the fiat system.

We can see where this overprinting will lead. As debt grows relative to gross domestic product (GDP), we would expect to see positive signs elsewhere, such as a growth in new jobs. But like a Tiananmen Square Rolex watch deal, the value simply isn’t there. Job growth is slow but, in reality, there is a decline in earnings. High paying manufacturing jobs have been replaced and exceeded by low-paying retail and health care sector jobs, so even if more people are at work, real earnings are down. Instead of simply measuring the number of jobs, an honest tracking system would also compare average wages and salaries in those jobs. Then we would be able to see what is really going on – more low-paying jobs being created, replacing high-paying jobs being lost.

Addison Wiggin

The Daily Reckoning

Editor’s Note: Addison Wiggin is the editorial director and publisher of The Daily Reckoning. Mr. Wiggin is also the author, with Bill Bonner, of the international bestseller Financial Reckoning Day and the upcoming thriller Empire of Debt. Mr. Wiggin is frequent guest on national radio and television programs.

The above essay was taken from Mr. Wiggin’s newly-released book, The Demise of the Dollar…and Why It’s Great for Your Investments. To order your copy, please see here:

The Most Important $11 You Will Ever Spend…

http://www.isecureonline.com/Reports/AFP/Dollar/

by Dr. Kurt Richebächer
The encouragement of mere consumption is no benefit to commerce because the difficulty lies in supplying the means, not in stimulating the desire for consumption; and production alone furnishes those means. Thus, it is the aim of good government to stimulate production, of bad government to encourage consumption.

- Jean-Baptiste Say, A Treatise on Political Economy, 1803
From discussing politics back to discussing economics. Just as before, though, it remains a dialogue among the deaf. The great majority of economists has its eyes stubbornly focused on apparently positive features for the U.S. economy, like the sharp fall in the oil price, abundantly available liquidity, tame inflation, low and falling interest rates and strong profits.
A minority of economists, in contrast, keeps just as stubbornly stressing that the economy’s famous gross imbalances and structural distortions and the associated debt explosion are inexorably undermining economic growth. In this view, the ongoing housing downturn will finally abort U.S. growth and drive the economy into recession, with major adverse spillover effects on consumer borrowing and spending.
Generally, however, optimism distinctly prevails about the U.S. economy. It is not the old buoyant optimism. Yet it is optimism in the sense that some true malaise, like a crash in the asset markets and a recession, let alone a deep and prolonged recession, are absolutely out of the question. Thanks to its superior dynamism and flexibility, the U.S. economy has time and again bounced back smartly from periodic downshifts, and so it will again.
Let us start with the hard facts. For six, seven and more months, U.S. economic data are overwhelmingly surprising on the downside, and moreover, the surprises have been going from bad to worse. Real GDP has successively fallen from 5.6% in the first quarter of 2006 to 2.5% in the second and 1.6% in the third.
That’s bad enough, but what rescued the latter quarter from total disaster was a rather quixotic statistical event. While auto firms slashed their output, it soared in the real GDP account, owing to sharp price cuts on gas guzzlers. In this way, falling vehicle output contributed fully 0.72 percentage points to third-quarter real GDP growth, after subtracting 0.31 percentage points. The price index for gross domestic purchases increased 2% in the third quarter, compared with an increase of 4% in the prior quarter.
It is an old wisdom that the scale of the boom excesses essentially determines the severity of the following process of economic and financial readjustment. It has been comfortingly argued that the U.S. housing boom of the last few years has been less fierce than prior booms, which all ended without steep price declines.
Certainly, there are different possibilities of measurement. For us, the most important, and also easiest, measure of excess is the associated credit expansion. The use of credit in the wake of this housing bubble has been simply bizarre, outpacing all past experiences by far. Over decades until 2000, outstanding total mortgages accumulated to $4.8 trillion. In the second quarter of 2006, they amounted to $9.3 trillion. Mortgage growth over the last five years was almost equivalent to its growth over the prior five decades.
The second highly important point to see is that this housing boom was the first one in the United States to impact the economy at a vastly broader scale than just the building activity. As private households, using the rising house prices as collateral for mortgage equity withdrawals, stampeded as never before into debt to finance additionally other kinds of spending, the whole economy developed into an outright bubble economy.

New single-family homes and multifamily homes rose in 2005 from a trough of fewer than 1.5 million units in recession year 2001 to a postwar high of 2.2 million units. Over the same period, the constant quality price index for new homes rose 30%, and the purchase-only price index of existing homes published by the Office of Federal Housing Enterprise Oversight (OFHEO) rose by 50%.
Boosting the net worth and the borrowing facilities of private households, this drove consumer spending to persistent considerable excess over income growth. In correlation, personal saving plummeted into negative territory, unprecedented for an industrialized economy.
It was a boom that plainly went to extraordinary excess in various ways. As a rule, this suggests a very severe aftermath of painful corrections. The first effects of the housing bust have definitely been bigger and more abrupt than most experts had expected. Yet hopes are riding high for a benign adjustment. To quote Federal Reserve Vice Chairman Donald L. Kohn from a recent speech: “The economy will grow at a moderate pace for a while, somewhat below the rate of increase of its potential, and then growth will begin to strengthen.”
Among his comforting arguments were first, the overbuilding in 2004 and 2005 was small enough to be worked off over coming quarters; second, this situation stands in sharp contrast to some past downturns in the housing markets that followed actions by the Federal Reserve to tighten credit conditions; third, as the inventory overhang in residential building and automobiles are worked off, economic growth should pick up again.
Mr. Kohn does not even mention that through the cash-out refinancing boom, this housing bubble had unprecedented spillover effects on the economy as a whole. In 2005, private households raised $1,080 billion through mortgages. Of this amount, they only spent $95.1 billion on higher residential building. Spending on goods and services rose altogether by $539.9 billion, against an increase in disposable income by $354.5 billion. In other words, about one-third of the increase in consumer spending depended on mortgage borrowing.
Actually, it strikes us how promptly the change in the housing market has impacted mortgage borrowing. It peaked in the third quarter of 2005 at $1,225.9 billion at annual rate. Falling steadily, it was down to $819.6 billion in the second quarter of 2006. This sharp decline was, however, to a small part offset by higher consumer credit.
Mr. Kohn stresses that monetary conditions remain quite supportive of borrowing and spending. Clearly, interest rates are so low that they exert zero restraint on borrowing. But more importantly, falling house prices no longer remain supportive for such borrowing. Remarkably, the sharp decline in new mortgage borrowing since the third quarter of last year has occurred even though house prices were still rising, albeit at sharply slowing rates. As the price climate is sure to deteriorate for some time to come, it seems a reasonable assumption that this initial sharp slowdown in mortgage borrowing has some way to go yet.
While this suggests further sharp falls in house prices, this may well take some time to materialize, because the housing market is notoriously sluggish in its reactions. In contrast to financial markets, its initial response to a change in the market situation is not in price, but on how long unsold homes stay on the market until the prices are lowered to realize desired sales. Sellers tend to resist downward price adjustments as long as they can. Instead, the market becomes illiquid. For sure, lenders will notice and adjust their lending conditions.
Mr. Kohn also takes comfort from the fact that the present housing downturn, in sharp contrast to past ones, is not caused by credit tightening. As he rightly stresses, “The Federal Reserve has returned short-term interest rates only to more normal levels and long-term rates are unusually low relative to those short-term rates.” We think, though, that he is drawing a totally false conclusion. All downturns caused by tight money were followed by vigorous recoveries. A downturn happening despite low interest rates and loose money seems to us the most worrying kind.
Regards,
Dr. Kurt Richebächer

for The Daily Reckoning
Editor’s Note: Dr. Richebacher has found the best investments to protect your portfolio, no matter what lies ahead for us in 2007. See his full report here:
Wealth Insurance

http://www.isecureonline.com/Reports/RCH/ERCHG805
Dr. Kurt Richebacher is the editor of The Richebacher Letter. Former Fed Chairman Paul Volcker once said: “Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong.” A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer’s insightful analysis stems from the Austrian School of economics. France’s Le Figaro magazine has done a feature story on him as “the man who predicted the Asian crisis.”

PEAK PERFORMER

by Justice Litle

“You’re seeing the earliest phase of natural gas history for the next 30-50 years… energy use goes in 50-year swings. You had wood, then coal, then oil and now natural gas.” – Fred Barrett, natural gas executive (quoted in The Wall Street Journal)

Energy pop quiz: In what century was the natural gas pipeline invented? A ballpark estimate will do. Take a moment to think about your answer.

Clearly, it wasn’t the 20th – that would be too easy. If you guessed the 19th century, you’re still out of luck. Eighteenth? Nope. Seventeenth? Still nowhere close.

As with many other inventions far ahead of their time, credit for the first gas pipeline goes to China. The Chinese built the original natural gas transport system out of bamboo poles. Chinese merchants used the gas to evaporate seawater and harvest the salt left behind. (Salt was a booming business back then, as it still is in some parts of the world today.) Confucius documented the existence of natural gas aquifers and bamboo pipelines circa 600 B.C. The Greeks actually discovered the “burning springs” as far back as 1,000 B.C. – but unlike the Chinese, they didn’t come up with a commercial use for the stuff. Around A.D.100, the king of Persia hit on the novel idea of using natural gas in his kitchen. Rather than bring the gas to the stove, though, the king did it the other way around. He had his royal kitchen built in close proximity to a gas spring, where the seepage fueled a continuous hot flame.

By the late 18th century, Britain was using manufactured gas (produced from coal) to light houses and streetlights. Baltimore was one of the first American cities to be lit this way, in 1816. Five years later, gunsmith William Hart dug the first designated natural gas well in Fredonia, N.Y. Hart, regarded by many as the Father of American natural gas, later founded the Fredonia Gas Light Co. – the first company of its kind. One of the key commercial developments for natural gas was the Bunsen burner, conceived by German scientist Robert Bunsen in 1885. Bunsen’s regulated mix of gas and air offered a convenient way to tame the flame, and thus greatly increase the safety and precision of its use.

Demand for natural gas continues to rise. The U.S. Energy Information Administration (EIA) expects natural gas consumption to increase more than 20% over the next few decades. Natural gas for electric power generation is expected to rise by more than 60%. This is largely due to its favorable profile as a low-particulate, clean-burning fossil fuel. Yet for all the steady rise in demand, production has been nearly flat for quite some time now. Domestic production growth over the last 10 years has come in at well under 1% annualized.

This snail’s pace is not due to sloth on the part of natural gas companies. The problem is that we are largely running to stand still. Existing wells are being depleted faster than new wells can be developed. Christopher Edmonds of Pritchard Capital Partners reports:

The average natural gas well in North America is experiencing accelerated decline rates. This year, the average well will post 30%-plus decline rates. That means we have to come up with that 30% decline in new production just to keep production flat. Simply, the production treadmill is moving faster every year… Even an increase in wells hasn’t helped. We have seen a nearly 50% increase in the number of producing natural gas wells since the beginning of this decade, and production has barely moved. It takes more wells – because yield per well continues to decline – just to keep production at existing levels.

America still has some pretty impressive swathes of untapped gas reserves tucked away. The problem is that most of those reserves are politically restricted, too hard to access or otherwise off-limits for various reasons. As with crude oil refineries, natural gas is an industry in which NIMBY and BANANA politics very much apply. (NIMBY = Not in My Backyard, BANANA = Build Absolutely Nothing Anywhere Near Anybody.)

Alaska has significant quantities of gas, but building a pipeline to the lower 48 would be wickedly expensive. Liquid natural gas holds significant possibility and meets only 3% of our current needs, but getting enough LNG terminals built poses a real headache. In the event of human error or terrorist attack, a burning LNG tanker could produce a fireball intense enough to burn someone a third of a mile away. Not the most appetizing prospect for local communities. There is also the matter of aggressive bidding from multiple countries for currently available LNG supplies. Capacity is swamped by demand. LNG is another promising area in which the infrastructure bottleneck is slowing things to a crawl.

Given the bullish long-term perspective, natural gas has nonetheless been driven down by bearish sentiment in the short to intermediate term. An unseasonably mild winter this past year, plus hefty storage numbers approaching 3 trillion cubic feet as of this writing, have both pushed natural gas futures to almost two-year lows.

It won’t take much for this pessimistic picture to turn on a dime. Bloomberg reports that “Natural gas has rallied in September in three of the past four years. Those gains were 21% in 2005, 34% in 2004 and 26% in 2002.” A nasty winter, or even just a normal one, could affect things greatly. Industry executive Fred Barrett tells The Wall Street Journal that “It only takes five-10 days of cold weather to wipe out about 400-500 billion cubic feet of gas.”

And unlike last year, The Farmer’s Almanac, which has a highly respectable track record for seasonal predictions, says we can expect bitter cold and plenty of snow for the winter ahead. Nor can future hurricanes be ruled out. Climate fluctuation ranges are expected to increase in coming years, as are tropical storms. The deep waters of the Gulf, a recent source of new supply hopes, are practically hurricane central.

Regards,

Justice Litle

for The Daily Reckoning

P.S. I’ve recently recommended to my Outstanding Investment’s readers a high-quality company with significant exposure to natural gas. It has significant hedges in place for future production, but with the crazy volatility swings natural gas can throw out, this is probably wise (and this company is experienced enough to profit on balance from natgas volatility, rather than be hurt by it). There is more than enough exposure for them to shine once the bullish case for natural gas reasserts itself, and then there’s the lingering possibility of an oil major takeover to boot.

To learn more about this company, and the other recommendations I have for my subscribers, see my latest report:

A Very Surprising Angle Will Make You Money

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Editor’s Note: Justice Litle is an editor of Outstanding Investments, ranked number one by Hulbert’s Financial Digest for total return performance over the past five years. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall).

HEDGE, I WIN…FAILS, YOU LOSE

by Bill Bonner and Lila Rajiva

Amaranth:

1. Also called pigweed.

2. An imaginary flower that never fades.

Last week investors found to their chagrin that the Greenwich, Connecticut genus of the pigweed, is not only far from imaginary, it can fade out at lightning speed. Hedge fund Amaranth Advisors managed to lose $4.6 billion – about half its entire value – in a matter of just a few days through a sensational miscalculation of the price of natural gas futures in the spring of 2007. Today’s news tells us the figure has now grown to $6 billion.

Star trader Brian Hunter bet the farm on the idea that the gap between the March 2007 natural gas price and the April 2007 would increase. Instead, it fell from about $2.60 per 1,000 cubic feet to about 80 cents, wiping out Amaranths’ 20 plus percent yearly returns, in one fell swoop, to a 35% loss.

Hunter, a Canadian, had made millions for the firm after natural gas prices exploded in the wake of Hurricane Katrina. He was thought to be so savvy about gas futures that his bosses at Amaranth let him work out of his home in Calgary, where he drove a Ferrari in the summer and a Bentley in the winter. The jazzy wheels matched the snazzy wheeling…and the honeyed dealing at the American energy fund, where 1.4% of net assets went for “bonus compensation to designated traders” and another 2.3% was doled out for “operating expenses.” When an account made a net profit, the manager took care to cut himself up to 1.5% of the account balance per year in addition to a 20% cut of its net profits – less the traders’ bonuses and operating expenses. But when the account lost money, the managers suffered no penalty, though the investors still remained on the hook for the operating expenses and possibly for trader bonuses as well.

What kind of a gig is that? Where investors have to pay to play and then pay to lose, as well? What can investors be thinking when they see their accounts shrivel like anorexics on a fat farm while their managers grow sleek and prosperous in their Greenwich pads?

The hedge fund world is famously populated by math whizzes, each one claiming to have solved Poincare’s Conjecture. But the important math of hedge funds is very simple: it’s heads I win, tails you lose.

The typical fund charges 2% of capital, plus 20% of the gains above a benchmark, often the risk-free rate of return – say around 5% today. So, a fund with a 10% return charges its clients 2% of capital…plus, another 2% (20% of 10%) for the performance. Even a fund that is able to do twice as well as the benchmark – a difficult feat – only leaves the investor with a 6% return, net.

A common pattern is that for four years in a row, the fund gets twice the return as the risk-free rate and every fifth year it suffers a 10% loss. When this happens, the fund managers do not send out a letter offering to share 20% of the loss. No, they are happy to take a percentage of the profits, but not the losses. So, in the four fat years, the fund builds up…with the managers taking their cut. But in the fifth year, investors take all of the loss, effectively magnifying it, making a dollar of loss equal to $1.25 of gain.

The essential math is not only easy…it is perverse. As demonstrated by Amaranth, fund managers have every incentive to take wild gambles. If the gamble pays off, they become rich and famous. If it does not, they are still the same math prodigies they were before. It is like playing strip poker with a beautiful woman. When you lose a hand, you take off your shirt. But when she loses, she puts on a leather coat.

Why do investors think they can get anywhere in such a game? The quick answer is that investors are not thinking.

In the late stages of empire, thinking becomes a vestigial function – about as useful as an appendix…and as liable to be cut out in a crisis.

Instead, investors rationalize…and theorize…to justify the excesses and extravagances of the imperial economy. Why buy a hedge fund? Better returns, they say – though hedge fund returns have been so abysmally low that their money would have slept sounder tucked up in a cozy money market account. Different market, they argue – claiming that the new conditions demand provocative trading rather than stodgy buying-and-holding.

Don’t marry your stocks, they warn. Just shack up for a few months and unload them when the next hottie comes along; that’s what the celebrity hedgies do. But filling your portfolios with fast moving floozies is no way to make money; they’ve all been on the street too long already…they’re overpriced and overworked. And when the market goes down, they’ll go down faster and further than more. The hedge funds have smarter managers, claim investors. And here, finally, they might have a point. Who but a real sharpie could have come up with such a clever scheme? Hedge fund clients might be dripping in red the past few years, but the fund managers themselves are in clover.

If vanity were gravity, Greenwich, Connecticut would be a black hole. The puffed-up twits who manage most hedge funds contribute to more unwarranted bluster per square foot there than in any place outside North Korea. Greenwich sucks in money from all over the financial world and turns it into…nothing.

In this respect, Amaranth is only following the hedge fund playbook. Deals for hedge bosses are so sweet that Warren Buffet claims the funds aren’t really investment vehicles at all but compensation strategies – ways to keep star managers in their multimillion dollar digs while the funds themselves turn in lower and lower returns…sub-10% on average, and in some cases, pushing below 5%, according to the Hedge Fund Index. In fact, in 2005, some 848 hedges closed down their business, says one consultancy firm, Hedge Fund Research Inc.

Is it just a case of too much of a good thing diluting the returns? Could be.

When Alfred Winslow Jones coined the term in 1949, hedge funds operated on the margins of the investment world. “Hedge fund” then simply meant a portfolio of stocks with long and short positions, the shorts acting as a hedge against losses in the longs.

Today, the term better describes the legal structure of the groups – private, and limited to a specific number of investors, with a minimum of $1 million in assets – and the actual strategies employed vary dramatically – from commodity trading to distressed investing.

And today, hedge funds have spread like a tropical parasite so that there are now 8000 or so of them, infesting even institutional investors and pension funds, and sucking in total assets of about $1.2 trillion. Meanwhile, hedge funds specifically engaged in energy trading – like Amaranth – have proliferated – soaring from about $5 billion to a stratospheric $100 billion.

You’d think this would give at least the pros in the business some pause. Yet, Morgan Stanley, for example, pumped five percent of its $2.3 billion fund of hedge funds into Amaranth. And, Goldman Sachs’ fund of hedge funds also admitted that an anonymous energy-related investment – guess who? – had wiped off a chunky three percent off its monthly return.

Hubris and excessive risk run through the entire sorry episode. Hunter himself was borrowing $8 for every $1 of Amaranth’s own funds, while taking positions ten times larger than veteran energy trader, Goldman, and twice the size of the next biggest trader. Hunter also expanded Amaranth’s natural gas holdings so that they became half the firm’s entire exposure, where they had once been only 7%.

Like LTCM – the energy firm that blew up in 1998 – Amaranth held such large positions in the market that it could not unravel its positions. Like LTCM, Amaranth seemed certain it would never fail and boasted of its “fearlessness” on its website. Like LTCM, Amaranth was hazy about what it was doing and how…

But unlike LTCM, the financial community is reacting with odd indifference to Amaranth’s fiasco. Peter Fusaro, co-founder of the Energy Hedge Fund Center, which tracks 520 energy hedge funds, shrugs that Amaranth is “a hiccup.” Amaranth’s blow-up doesn’t affect as many institutional investors and banks and other financial VIPs, as LTCMs did. Only its rich clients have to endure the pangs of portfolios sliced neatly in half.

Maybe so.

Maybe not.

We think of the typical hedge fund manager. Not yet 30, no experience of a real bear market, let alone a credit contraction…the man thinks only of the new house he will build in Greenwich, Connecticut, if his bets pay off. He imagines that he will take his place alongside George Soros and the Quantum Fund.

More likely, he will join Nicholas Maounis in the pigweed.

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 Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).   

In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount – just click on the link below: 

The Most Feared Book in Washington!

http://www.dailyreckoning.com/empireofdebt.html

THE NATURE OF DISASTER

by Byron W. King

What is a disaster? The Latin roots of the word are “dis” and “astro.” Literally, the two combined words mean “ill-starred.” In ancient times, if you offended the gods, the deities would align the stars against you and bring a bad set of events down upon your house, if not upon your head. So the word itself has come to mean, according to the Oxford English Dictionary, “a sudden or great misfortune; an event of ruinous or distressing nature; a calamity; complete failure.” Let’s look at some examples, just to illustrate the point.

In classical times, there was hardly a more disastrous event, or an event with more calamitous outcome, than the Athenian invasion of Sicily in 415 B.C. This disaster was chronicled by no less than Thucydides in his classic work, The Peloponnesian War. The short version of the story is that the Athenians had been fighting the neighboring Spartans for many years and eventually decided to attempt to break what had turned into a military stalemate. The Athenians determined to outflank their enemy by sending an army halfway across the Mediterranean Sea to Sicily and raising a threat to Sparta’s rear.

But talk about offending the gods? Someone sure did. (Thucydides said that it was Alcibiades, but who really knows?) The Athenians were filled with hubris at the prospect of their own success. But their distant expedition met with trouble from the outset, encountering almost every form of problem that a distant military campaign could have. And once the Athenians had landed on the shores of hostile Sicily, things went from bad to worse. After losing a major battle at the Sicilian town of Syracuse, the Athenians were thrown into headlong retreat. Eventually, the soldiers of Syracuse caught up with the main body of Athenians at the Assinarus River, on the southeast coast of Sicily. There, according to Thucydides, the thirsty Athenians were slaughtered in droves as they trampled each other trying to get to the water.

Thucydides summed up the expedition to Sicily in sad words, but words that still convey the sense of total loss. In the end, he wrote, “They were destroyed, as the saying is, with total destruction, their fleet, their army, everything was destroyed, and few out of many returned home. Such were the events in Sicily.” Now there is a disaster for you.

“But mankind has moved beyond these sorts of things,” some people still say. Yes, of course. Except that we humor ourselves when we say such things. The same sorts of calamities still occur. We suffer from the same sense of hubris that doomed the Athenian army and the good ship Titanic and its captain. Mankind still has that almost willful blindness to exercising the vision to forecast and avoid disaster in the making.

For an example of a modern disaster, no one who was around at the time could ever forget the famous words broadcast from NASA’s Mission Control on Jan. 28, 1986, perhaps the understatement of the age: “It appears we have had a major malfunction of the vehicle.”

“A major malfunction?” Space shuttle Challenger had just exploded, less than two minutes after liftoff. The vehicle was destroyed. The crew was killed. Debris rained down from the sky, falling into the blue sea offshore Cape Canaveral. And it was all on television, live and in color, no less.

The immediate cause of the Challenger disaster was a faulty device called an “O-ring,” part of an otherwise tight seal between two sections of one of the solid rocket boosters. When cooled to a freezing temperature, as had occurred on the cold night before the deadly launch, the rubber in the O-ring lost its resilience and became somewhat brittle. During the stress of launch, the exhaust from the solid rocket booster literally burned through the O-ring, causing the rocket booster to shift from its proper position in flight, resulting in a sequence of failure events that led directly to the explosion that destroyed Challenger and killed the crew.

So can we really say that a disaster results from just the single triggering event? Of course, every disaster has its penultimate cause. In Sicily, the Athenians lost a battle at Syracuse. The O-ring on one of Challenger’s booster rockets burned through. But is this the end of how to think about it? Not by a long shot. Thucydides, for example, writes his history but does not shirk from detailing a chain of errors and misjudgments on the part of the Athenian leaders who sent their army to its doom in Sicily.

In the case of the Challenger explosion, no less a mind than Richard Feynman, physicist and Nobel Laureate, noted that the source of the explosion was a pervasive cultural disease within the institution of NASA. Feynman noted that NASA had evolved away from its roots as a scientific and engineering agency within the U.S. government to become a vast bureaucracy that allowed safety standards to slip, and which permitted grievous errors to go unnoticed for years at a time. To paraphrase Mahan, NASA had become a “system” that allowed its bureaucratic nature to “pervert standards.”

Now that we have discussed a couple examples of famous disasters, let’s take a look at the idea of “financial disaster.”

“What is a financial disaster? The phrase brings to mind images of panicked merchants huddled around an exchange waiting for the latest news to arrive via post, telegraph, or computer, of stock market crashes, of unemployment and charts showing a precipitate drop in the price of shares, indexes, or currencies.”

The foregoing comes from the introduction of a remarkable three-volume set of books entitled History of Financial Disasters 1763-1995, released in April 2006 by the London-based firm of Pickering & Chatto.

As the title implies, these three volumes review the origins and consequences of the Western world’s most important financial crises in the past quarter millennia. The editors have chosen to highlight and delve into 19 seminal economic crises between 1763-1995. Rare public and private papers, offering trenchant firsthand accounts from some of the principal insiders, offer rich source material and penetrating background on the events that occurred. In addition, the editors have culled the stacks of academic literature to assist the reader in interpreting these events and in drawing conclusions and lessons for our own time.

There are only a few people in the economic world that could have assembled this type on insightful collection. The general editor of this important historical review is Mark Duckenfield, an accomplished economist and historian at the London School of Economics. With the able assistance of co-editors Stefan Altorfer and Benedikt Koehler, also accomplished economic historians, Dr. Duckenfield has cast a broad net to gather what are among the best source materials that could be found in the world.

In general, the editors follow the definition of “financial crisis” established by the great analyst Charles Kindleberger. That is, financial crises are “associated with changed expectations that lead owners of wealth to try to shift quickly out of one type of asset into another, with resulting falls in prices of the first type of asset, and, frequently, bankruptcy.”

Thus, according to the editors, financial crises are a product of sudden alterations of expectations, rooted in reality or imagination. If you are looking for a way to avoid financial disaster, this is the key level of understanding. The impending alteration of people’s expectations sends a glaring signal to which you should train your mind to react.

In these three volumes, and for each of the financial crises that bears examination, the editors provide the reader with a look beyond the immediate crisis itself, and a view of the series of events that constituted the whole disaster. Here is the true value of this set of books.

The editorial approach is similar to the way that one might view the onshore wreckage caused by a hurricane, and from which natural disaster the recovery efforts can take years to come to fruition. In other words, the landside wreckage is only the most visible feature of a natural phenomenon that had its origins far out to sea. To avoid the impact of the storm, you should learn to forecast the weather. And then prepare yourself for the hit, if not just plain get out of the way.

The editors use a broad conception of financial disasters that includes objectively describing the origins and resultant consequences of the phenomena. But the editors go many steps further as well by presenting information about how each disaster related to broader themes of the times. This includes providing the reader with fascinating information about the historical context, changes in the view of government intervention in the economy, the development of broad economic thought, the role of the media, and the openness (or what we now call “globalization”) of markets.

Large-scale changes could be triggered by the dawn of a realization that a government’s currency policies were highly inflationary. As an example, the editors review both the French Assignat inflation of the 1790s and German Weimar hyperinflation of the 1920s, and what followed when people came to realize that their currency was plummeting to worthlessness. Or people may begin to perceive that a government might have less political stability than had previously been thought, such as occurred with the Mexican peso crisis of 1994. On occasion, the financial meltdown begins not with overt monetary inflation, but with the pricking of a credit balloon and associated asset price bubble, such as the New York crashes of 1929 and 1987. Or there could be a herd mentality when investors respond to rumors and fears of insolvency, as with the collapse of the British entity of Overend & Gurney in 1867.

In addition, no one can consider himself or herself knowledgeable about the origins of modern monetary policy, and, in particular, the role of the U.S. Federal Reserve, without a solid grounding in the events of the Crisis of 1907. This section alone ought to be required reading for anyone who wants to understand the Fed and its origins, as well as its future direction as the U.S. dollar continues its century-long decline in value.

Every disaster has its proximate cause, the roots whence it grows. The Athenians lost a battle at Syracuse. The Titanic hit an iceberg. The O-rings of space shuttle Challenger became brittle in the cold. But as we discussed, there were deeper causes and origins, not to neglect the general human affliction of hubris.

Until next we meet,

Byron King

for The Daily Reckoning

P.S. History of Financial Disasters 1763-1995 is a treasure chest of historical perspective on the subject of economic and monetary disasters, and a valuable tool in your personal workbench of financial and historical knowledge. These books give you insight into the origins and consequences of financial disasters.

As I said at the beginning of this review, if your goal is to avoid something whose effects are not good, it certainly helps to know what that particular something looks like, and to understand its nature. Then at least you can get your money off the table and get yourself out of the way when it is headed in your direction. You could not do better than to read these three outstanding volumes and work to acquire the financial insight that might make all the difference in the world to you and to your family when the economic ship hits the next iceberg.

Purchase your copy by clicking here:

History of Financial Disasters 1763-1995

http://www.isecureonline.com/Reports/905SHFD/E905G900

Editor’s Note: Byron King currently serves as an attorney in Pittsburgh, Pennsylvania. He received his Juris Doctor from the University of Pittsburgh School of Law in 1981 and is a cum laude graduate of Harvard University. He is a regular contributor to the free e-letter, Whiskey and Gunpowder, which covers resources, oil, geopolitics, military history, geology and personal freedom. To get your free subscription, click below:

Whiskey and Gunpowder

http://www.whiskeyandgunpowder.com/Sub/DR.html

by Chris Mayer
Crops withering under the blistering gaze of the sun. Cracked mud flats curl along the edge of shrunken waterways. Fish lie dying on the dried riverbeds. And in the evening, the orange glow of wildfires pulses against the dark sky like the glow of a torch. This is not some eerie scene from a science fiction movie. This is summer in Spain in 2006, victim of drought.
Spanish water reservoirs were at only 45% capacity in August. In the tourist-heavy southeast, they were as low as 8%, getting close to the sludge at the bottom. Spanish farmers face severe water restrictions and the prospect of a much smaller harvest. They will lose hundreds of millions of euros as a result. Fires peppered Spain’s parched forests. In the first week of August alone, there were over 100 forest fires in northern Spain, killing at least three people. But it’s not just Spain that is parched. Much of Western Europe suffers from unyielding drought.
Drought has even touched the normally deep and powerful Rhine, the busiest waterway in Europe. The proud old river is a shallow and feeble portrait of its old self. Ships must carry less cargo than they once did. And shipping companies recently imposed surcharges of 50% to make up the lost revenue.
The hot dry summer has a ripple effect on European life. According to the Financial Times: “Desperate to conserve water, Paris has for the first time decided not to dampen the dusty paths of its public gardens. English gardeners are banned from using hosepipes, while swimming pools remain empty in many Spanish towns.”
The tight water constraints also threaten livestock, as favored lush meadows and cool watering holes are now dusty fields and clumpy mud puddles. Harvest of beets, rice and corn will approach record lows.
Some may think that this is all just temporary. After all, occasional drought is part of life on this unpredictable little planet – like rain on summer barbeques and clouded-over picnics. But it is more than that. The record high temperatures expose deeper problems in how we manage our precious water resources.
Among those lying exposed are farmers. Farmers waste a lot of water. They would probably prefer not a lot of people know about this habit (as don’t bed-wetters). But it is impossible to ignore.
In Spain, agriculture uses about three-quarters of the country’s water. Yet according to Spain’s environment ministry, at least 80% of that water is wasted. Some is lost through leaking infrastructure or inefficient irrigation techniques. Heavy farm subsidies also discourage efficient use of water resources and lead to waste.
The solution is apparent. Europe needs more investment in water infrastructure, such as reservoirs and improved pipe systems. It needs more efficient irrigation systems and greater reliance on market incentives to encourage smarter water use. It’s a tale told in hundreds of other places.
The irrigation angle is really the cake frosting to this story. It is the most appealing part, because the need for greater efficiency is so widespread. And there is actually an investment idea buried in here.
In most countries, agriculture is the largest consumer of water. The less developed the country, the more agriculture tends to consume. As I’ve said, much of this is wasted. By some estimates, half of farmers’ water use does not produce any food at all.
Therefore, minor changes in use can have a dramatic impact on the supply of water. As Fredrik Segerfeldt writes in his excellent book Water for Sale: “A 10% improvement in the distribution of water to agriculture would double the world’s potable water supply.” Using drip irrigation to grow tomatoes, instead of traditional irrigation, for example, lowers the amount of water used by about a third.
Improved irrigation is a crucial component of better management of water resources. The most telling statistic of all is this: Irrigation waters only about 17% of the world’s farmed acreage. Yet that irrigated acreage produces 40% of the world’s food supply. That is astounding productivity. It also shows why irrigation technology will figure prominently in solving water supply problems.
One company I recommended in Mayer’s Special Situations makes irrigation equipment. Though its headquarters are deep in the American Midwest – in Omaha, Neb. – this company is a global player. Farmers use its irrigation systems to water crops, nurseries, turf, pasture and much more. Their products improve water efficiency and boost crop yields.
About a third of its sales come from overseas. This piece of the business has a bright future. Management estimates that international sales will make up half of the company’s sales in the next five years. They are in all the hot spot markets you would want to participate in – China, Africa, Brazil, Australia and, of course, Europe.
And the business is booming. Revenues were up 34% last quarter. Profit margins are up. Earnings nearly doubled. The backlog is up 73%. The company is in great financial shape. It’s got lots of cash and marketable securities – more than $4 per share on a $27 stock – and no debt. Finding companies with all these attributes these days is a rarity – like pitchers who hit home runs.
It may seem expensive at 31 times trailing earnings. But earnings are growing rapidly. Next year, this stock could easily earn well over $1 per share. Backing out that extra cash gives you a multiple of around 23. Not bad for a company ramping up earnings as quickly as they are.
Regards,
Chris Mayer

for The Daily Reckoning
P.S. Though there are always choppy ups and downs in the ag markets, I like the long-term story with this company. And every time we have drought and water constraints, practically anywhere in the world, it will be hard to ignore this company’s solution.

To find out more about this small corporation in the midst of a powerful secular trend, see my latest issue of

Capital and Crisis

http://www.agora-inc.com/reports/FST/EFSTG908 
Editor’s Note: Christopher Mayer is the editor of Capital and Crisis and Mayer’s Special Situations. Chris began his career in corporate banking after earning an MBA with a concentration in finance. He later started Capital & Crisis, a monthly newsletter that gave Chris’ unique brand of financial commentary a more regular and expanded format.

LIARS’ LOANS

by Bill Bonner

On Tuesday came news that the house of Goldman continues to prosper. The company announced record profits. It also announced that its 25,647 employees would make more than half a million dollars a piece this year – a 19% increase over last year.

On that very same day, a headline proclaimed the latest milestone in another, possibly related, trend: the U.S. trade balance hit another record, at $68 billion for the month of July.

How these two bits of synchronicitous news are related would be a good subject for an issue of The Daily Reckoning, we thought. But that is not our theme today; instead, we will turn our focus to Goldman and Greenspan, along with a supporting team of millions of witting, unwitting, and completely witless accomplices have wrought.

The housing bubble in America is losing air; the papers are all over the story. While the evidence is mixed, cocktail conversation has turned from how much money people have made by selling their houses to how much money they might have made if they had sold a little earlier.

But while lips tell the stories, the message still hasn’t arrived at the part of the brain that can add two and two. Homeowners are still borrowing and spending; they have not yet cut back in anticipation of harder times ahead. And financiers are paying big money for derivatives and the companies that produce them. While the credits creak and wobble, the creditors haven’t seen so much M&A activity in 10 years. Merrill Lynch, for example, just paid $1.3 billion to acquire National City Corporation’s mortgage origination business. And, judging by profits (Goldman’s are up 16% over last year), bonuses, and prices – the masters of the financial paper shuffling business are in high cotton.

What is Goldman? Among people who package and sell debt in large volumes and at large prices it is the leading brand. Debt comes in many varieties and many forms – especially after Goldman gets finished with it. But the variety called “mortgage backed securities” is worth looking at more closely…if not for illumination, at least for amusement.

A mortgage-backed security is backed by a mortgage. But what backs up the mortgage?

We put the question to an Irishman. “These houses are so expensive…how can people afford to buy them?”

“Ah…you might wonder what the real source of this Irish Renaissance is. It is debt, pure and simple. We had interest rates of 10% or more – until we joined the European Union and got the euro. Then, all of a sudden, you could borrow money for only 3%. You can imagine what that did – the whole place went on a spending spree – mostly concentrated on property, because the Irish love owning their own houses. I think it is something left over from the British rule, when we weren’t allowed to own property. Now, we can own it…and now, with these interest rates, we can afford it. At least, as long as the lenders will keep lending on favorable terms. Right now, they practically stop you on the street to try to give you money.

“That’s the real secret. The Germans had worked and saved for decades…and developed attitudes about money and institutions…all these things that allowed them to have interest rates around 3% without going crazy on credit.

“Then, when that low borrowing rate was introduced to Ireland, it was as if the pubs were giving away free pints 24 hours a day. The party has been going on ever since.

“So you see, we have everything you have in America: a property bubble even bigger than yours…with interest only housing loans… new cars everywhere…new buildings…everything.”

The one thing the Irish do not have – a property bust – we predict they will get soon. Good and hard.

So far, the property bubble has added $30 trillion to the “wealth” of the developed countries alone. Borrowers may have been inclined to stop spending years ago, many would have gone broke, but the lenders wouldn’t let them. New ways of letting out money were developed…each one more exotic, and more tempting, than the last. Not only could the mark pay less-than-market rate interest on his loan, and make payments when and if he chose to do so, he was also allowed to borrow with no proof of income; in these “liars’ loans” whatever he stated as his income was taken down for fact.

While, down low on the economic food chain, men in cheap suits sold ARMs to people with hardly a financial leg to stand on, up higher, better dressed pitchmen derived from these dubious credits highly leveraged “securities” which they offloaded onto supposedly sophisticated financial institutions.

It is one for the financial history books. Conditions for credit expansion had never been better than they were in the last quarter of the last century of the 2nd millennium and the first few years of the next. In 1971, the world’s money lost all contact with reality. The dollar, completely freed from gold, could be stretched almost infinitely. And then, Paul Volcker crushed excessive inflationary expectations in the early ‘80s, while increasing globalization helped hold down consumer prices. And then began the great bull market in bonds…in stocks…in houses…in credit generally, and credit derivatives in particular. And now the whole world floats in the biggest bubbles ever – expanded, among other things, by $236 trillion worth of [notional value] derivatives.

“We have no idea what will happen in the next 12 months,” we told our audience in Dublin. “No one seems to think these bubbles will blow up. And since they’re not worried about it, insurance against a blow-up is fairly cheap. Put options, for example, are a bargain. Gold at less than $600 is a bargain too.

“Not that we expect gold to soar. Gold may go up. It may go down. But it won’t go away. When the credit expansion turns into a credit deflation a lot of other credits will disappear.”

That is when the liars default on their loans. And Goldman’s bonus checks get smaller.

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 Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons). 

In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount – just click on the link below: 

The Most Feared Book in Washington!

http://www.dailyreckoning.com/empireofdebt.html