The monetary system will fall apart - The Daily Reckoning
The Daily Reckoning by Bill Bonner
On This Day - 25 May 2010
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Paris, France

Today, the euro. Tomorrow, the dollar.

The euro is taking a beating. Investors are worried that it won't survive Europe's debt problems.

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Note, we said 'debt' problems. Many experts still believe it is a liquidity problem. That is, they think it's just a problem of finding financing. They blame speculators and hedge funds for panicking...or for deliberately cutting off the flow of juice.

But the speculators are just doing their job. They see that the real problem is debt. Greece, for example, has government debt equal to 120% of GDP. It's too much... And even if all their austerity measures are put in place successfully - that is, if the Greeks go along with proposed budget cuts - the level of Greek debt will still increase, to 150% of GDP.

In other words, the fix makes things worse, not better. Debt needs to be defaulted...and restructured...not increased.

And it's not even sure that the fix will happen as planned. Spain's big unions are planning a huge strike for June 8th. Malcontents, anarchists, public employees, retirees - all are resisting budget cuts. And as long as the fix is in, they figure they can get away with it. Most likely, the only way to really rein in spending is by cutting off the money.

With the cuts or without them, the situation looks bad. What will happen? Some think Germany will leave the euro. Others think Greece and Spain will leave.

Who knows?

But the euro is not alone. The worst deficit on the east side of the Atlantic is not in Greece. It's in England. And the worst household debt is not in Spain; it's in England too.

Not surprisingly, the pound is falling. This week, speculators are betting against sterling at a record level.

And the US dollar can't be too far behind. From the US to Britain to Greece, the basic numbers are very similar. Debt and deficits are high - with no obvious way to bring them down.

"Divided Europe Spreads Contagion Fears in US," says a Reuters headline.

Reuters sees the effect; it misses the cause. Debt is not catchy. It's more like cirrhosis of the liver or lung cancer. It's the result of behavior, not the result of contagious disease.

Yesterday, in New York, the Dow gave back the gains it registered on Friday. It was down 126 points. It is clearly headed down. The question we've been asking ourselves: is this just another downtrend...or THE downtrend.

We've seen the top. Somewhere up ahead is the bottom. At the top, stocks sell for more than 20 times earnings. At the bottom, they sell for less than 10 times earnings...maybe as little 5 times earnings.

If this is
THE big downtrend, it will keep taking stocks down until it finally reaches bottom - even if there are a few bounces and countertrends along the way. Look for Dow 5,000 or less - sometime in the future.

In the meantime, gold went way up yesterday - a $17 gain. The fundamental problem in the western world is debt. That debt is stated and measured in terms of paper money. Rather than let the debt go bad, governments are trying to increase the supply of money so that debtors will be able to pay. But governments don't have any money, so they have to issue more debt first (magnifying the problem). Then, when governments can't pay, they will probably issue more paper money to cover the problem. How this will play out exactly, no one knows. But it is sure to spell T-R-O-U-B-L-E.

And when there's trouble, people turn to gold.

Here at the Daily Reckoning, our guess is that the bull market in gold will continue until the monetary system finally falls apart. Then, the dollar, the pound and the euro will ALL be going down - fast - against gold and other real assets. And all forms of debt, denominated in paper currency, will be marked down sharply. Many will disappear...worthless...

And here we offer a prediction:

The employees of the US Federal Reserve will ask to be paid in gold before the crisis is over.

*** Banks aren't lending to private businesses. And now, they can't raise money from the bond market either: Sales of corporate bonds have collapsed.

Bloomberg reports:

"Corporate bond sales are poised for their worst month in a decade, while relative yields are rising at the fastest pace since Lehman Brothers Holdings Inc.'s collapse as the response by lawmakers to Europe's sovereign debt crisis fails to inspire investor confidence.

Companies have issued $47 billion of debt in May, down from $183 billion in April and the least since December 1999, data compiled by Bloomberg show. The extra yield investors demand to hold company debt rather than benchmark government securities is headed for the biggest monthly gain since October 2008, Bank of America Merrill Lynch's Global Broad Market index shows.

Concern that European leaders won't be able to coordinate a response to rising levels of government debt from Greece to Spain, while U.S. legislation threatens to curb credit and hurt bank profits, is driving investors away from all but the safest securities. The rate banks say they charge each other for three- month loans in dollars has almost doubled since February.

"This is a quintessential liquidity crisis," said William Cunningham, head of credit strategies and fixed-income research at Boston-based State Street Corp.'s investment unit, which oversees almost $2 trillion. "It's not inconceivable to imagine a situation where the markets behave so poorly, the liquidity behaves so badly, and risk-tolerance just evaporates that -- particularly in Europe -- consumers contract, businesses stop hiring and stop investing, and economic activity halts."

Mr. Cunningham doesn't understand what is going on. It's NOT a liquidity crisis...It's a debt crisis...aggravated by a stupid government response.

Almost all capital in the western world (and Japan, for that matter) is going to the government. The private sector is deflating...the public sector is inflating...

...the whole process will continue until it blows up.

*** Is there a bubble in Chinese real estate? We asked our new friend in China; Fred Hsu says 'it's not that simple:'

A WORLD OF DIFFERENCES

With the US real estate bubble popping still fresh in people's memory, its easy to read a few headlines and jump to the conclusion that China is experiencing a similar real estate bubble. But what is a real estate bubble? If the definition of a real estate bubble is what happened in the US, then China is not experiencing a real estate bubble......yet.

The US real estate bubble was characterized by EXCESSIVE RECKLESS CREDIT. Banks competed with each other in LOWERING lending standards. Creative solutions were devised for loaning money to people that shouldn't qualify for loans. Banks even competed with each other to lend money to people that most probably could not pay them back. Wall St. then bought these risky loans, repackaged them, made them appear investment grade by insuring them, then sold them to financial institutions around the world. All this was going on with the US government encouraging reckless lending.

China real estate is a different story. On the surface there are some visible similarities such as completed real estate projects with low occupancy, but upon closer examination, there large differences.

For starters, a lot of China real estate is purchased with CASH. There are no bank loans involved. Some Chinese buy real estate as a store of wealth. They don't try to rent out the property, but hold the hard asset as protection against inflation. Property taxes in the US are paid each year, but property taxes in China are a one time event occurring at the time of purchase. If you don't have any loans to service or even property taxes to pay each year, leaving a property unoccupied is not a financial burden. Unlike US buyers whom borrow heavily to purchase property, Chinese buyers are generally in a position of financial strength.

For Chinese that do need a bank loan, the lending standards are higher than in the west. Chinese banks will only appraise the value of a property to be 80% of the property's market value. This forces the buyer to put in 20% extra down payment on a property. This additional equity in a house gives Chinese banks a margin of safety in case the borrower cannot repay his loan. Unlike the US where banks were originating loans then selling them to Wall St.; Chinese banks actually keep the loans they make on their own books. This incentivizes Chinese banks to only make loans where they can get their money back.

The Chinese government is taking measures to cool down the real estate market. This is not the first time they've attempted this. The recent measures include requiring over 50% down payment for a second home and stopping bank loans completely for third homes. The Chinese government implemented these measures not because they fear financial trouble, but because they fear social unrest. Property prices have risen much faster than wages making affordable housing outside the reach of most Chinese. Social unrest is the greatest fear of the Chinese government leaders. Unlike the US where the government encouraged excessive lending, the Chinese government is putting up lending restrictions.

The China real estate market is a complicated subject with many moving pieces. Looking at the surface, there are similarities to the US real estate, but detailed analysis reveals a world of differences.

If the definition of a real estate bubble is what happened in the US, then there's no bubble in sight."

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

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