"What's the capital of Iceland?"

"Oh…about $6.50."

That's the joke that is making its way around London this morning.

Iceland has melted down. Now, the government has pledged to save the banking sector - but at a cost of nearly $500,000 per citizen! In Europe, the cost so far is estimated at about $7,000 per citizen. But experts insist that much of that money - loaned to the banks - will come back to the government.

And in America? Who knows…?

The subject is on every pair of lips. It has replaced the weather as the focus of casual conversation.

"How 'bout what is going on at the banks," say farmers to one another.

And on the radio, talk shows are alive with recriminations, conspiracies and finger pointing. The man on the street is like a palm tree in a hurricane, wondering what makes the wind blow so hard.

On Monday, the wind shifted. The Dow shot up - along with the rest of the world's stock markets. People looked up and saw sunshine. But was it a genuine end to the storm…or just the eye of the hurricane that was passing over?

Then, yesterday, the clouds came back. The feds announced that they had to force an evacuation. Capitalism would have to leave town - at least temporarily. They partly nationalized nine U.S. banks.

The Financial Times recorded the scene at the Treasury Department as they told the world:

"America is a strong nation. We are a confident and optimistic people," declared Hank Paulson, Treasury secretary.

"Our confidence is born out of our long history of meeting every challenge we face." But then reality reared its ugly head. "There is a lack of confidence in our financial system…it poses an enormous threat to our economy. Investors are unwilling to lend to banks, and healthy banks are unwilling to lend to each other."

So was America confident or terrified? Apparently, it was confident that it could stop being terrified - but only if the government came to the rescue.

Deputy undertaker Ben Bernanke, Federal Reserve chairman, stared grimly into space; Sheila Bair, head of the Federal Deposit Insurance Corporation, nodded occasionally. Tim Geithner, president of the New York Fed, stood with both hands in his pockets, looking concerned.

Mr. Bernanke's turn came next, promising to do whatever it took to save the nation from disaster while letting slip that even yesterday's giant intervention might not be enough. Then up strode Ms. Bair, her head barely visible above the podium Mr. Paulson had towered over, to detail the "extraordinary steps" the government was taking to save its banks.

Saving the economy would require "a sustained and coordinated effort by government authorities". People may have lost faith in the private sector but not the power of federal authorities to rescue them. "Above all else, there must be no doubt in our government."

Ronald Reagan must be turning in his grave, the FT concluded.

But the deed was done with hardly a peep of complaint. Those few who were inclined to peep were pushed aside and ignore.

The Dow fell 76 points yesterday - a bad sign. Usually, following such a bad week, you'd expect the dead cat to bounce for several days. This one had a good bounce on Monday and then lay as still and as silent as a tax collector's tomb.

This is an 'emergency;' everybody says so. All very well to take the high road when the weather is fine. But when storms come, people look for shelter wherever they can find it.

How bad will the storm get? This from Nouriel Roubini, Professor of Economics at the NYU Stern School of Business:

"The crisis was caused by the largest leveraged asset bubble and credit bubble in the history of humanity where excessive leveraging and bubbles were not limited to housing in the U.S. but also to housing in many other countries and excessive borrowing by financial institutions and some segments of the corporate sector and of the public sector in many and different economies: an housing bubble, a mortgage bubble, an equity bubble, a bond bubble, a credit bubble, a commodity bubble, a private equity bubble, a hedge funds bubble are all now bursting at once in the biggest real sector and financial sector deleveraging since the Great Depression.

"At this point the recession train has left the station; the financial and banking crisis train has left the station. The delusion that the U.S. and advanced economies contraction would be short and shallow - a V-shaped six month recession - has been replaced by the certainty that this will be a long and protracted U-shaped recession that may last at least two years in the U.S. and close to two years in most of the rest of the world. And given the rising risk of a global systemic financial meltdown, the probability that the outcome could become a decade long L-shaped recession - like the one experienced by Japan after the bursting of its real estate and equity bubble - cannot be ruled out.

"At this point the risk of an imminent stock market crash - like the one-day collapse of 20% plus in U.S. stock prices in 1987 - cannot be ruled out as the financial system is breaking down, panic and lack of confidence in any counterparty is sharply rising and the investors have totally lost faith in the ability of policy authorities to control this meltdown.

"A vicious circle of deleveraging, asset collapses, margin calls, and cascading falls in asset prices well below falling fundamentals, and panic is now underway."

And, looking in our old book, Financial Reckoning Day, written with Addison Wiggin, we find this remarkable forecast:

"If the US were to repeat the Japanese experience, stocks would be expected to return to their 1995 trend line, with the Dow below 4,000 in the year 2012, at the very moment when America's baby boomers will most need their money."

Get out your galoshes, dear reader…

*** We're rushing to the airport - on our way to the Frankfurt Book Fair, where we hope to receive a prize for our latest book - Mobs, Messiahs and Markets. Paul Krugman got his Nobel. We're hoping for something too…perhaps a little smaller.

But we are working hard on our Special Emergency Report, where we hope to present a clearer picture of what this crisis really means and how you can survive it…and even enjoy it. Look for it soon.

*** Yesterday, we mentioned that our friend and colleague Chris Mayer, amidst all the racket in the markets, has found two new buys for his Mayer's Special Situations portfolio. As we said before, we can't give specific stock picks in The Daily Reckoning (it is a free newsletter, after all), but we can tell you some things about the second buy Chris has re-discovered. We'll let him give you the scoop:

"It's a company we've owned before at MSS and more than doubled our money on. But the recent carnage in the market has taken it down, even though the company has created a lot of value since we sold it. It's a great buy today and it looks like a double, at least, again!

"The stock was $95 in July. We can grab it for $40 today…

"It's also one of the best owner-operators I've ever found. Consider some of these things:

- The company has only 6 employees
- The management team owns 24% of the stock.
- The company has no debt.
- It should generate $300 million in cash flow this year and has a market cap of just under $700 million. Meaning, it's trading for little more than 2 times cash flow. My goodness, if I could only find one of these every month I'd be a rich man in no time at all!"

To learn more about this pick, and the rest of Chris' MSS portfolio, see here.

*** In the meantime, we are getting in the spirit of saving money. Last week, we rode a bicycle home from the office.

"You must have looked like the nutty professor," said our daughter when we described the scene to her. Bicycle riders feel a sense of superiority and invulnerability that you can't get in a car or on foot. The rider-propelled, two-wheeled vehicle gives a sense of liberation to scofflaws…and a sense of power to poets. Your editor nearly ran down at least two pedestrians who got in front of him. As for the automobiles, he ignored them…and traffic signals too. Bicycles always seem to have the right of way…and never get traffic tickets. So, he zoomed down the Rue de Rivoli, ringing his bell to get the pigeons and old ladies out of his way. And then he glided through roundabout at the Place de la Concorde…right through six lanes of traffic. Drivers honked at him. Even other bicyclists seemed alternately alarmed or annoyed. But he got home. Safely? Probably not, but at least he was saving money.

Until tomorrow,

Bill Bonner
The Daily Reckoning

The Daily Reckoning PRESENTS: If the Fed continued on its austerity program (with respect to the printing press), says Ed Bugos, below, the dominoes would no doubt continue to fall. This would be a process of returning the economy to equilibrium, if you will. Keep reading…

DEFLATION IS A NON SEQUITOR
by Ed Bugos

It looks like Bill Gross has stumbled upon his bull market.

But so have gold bugs and, after today, maybe gold share investors also.

There are only two things gold bulls should worry about from this point forward, now that the general commodity correction is out of the way and the froth has been worked out of the market: deflation in the strict sense of the term (monetary, not asset deflation) or a suddenly brightening economic outlook, both of which, in this writer's opinion, would require a political austerity hardly imaginable these days.

As far as deflation goes, we saw that the Federal Reserve inflated its balance sheet by an astonishing US$600 billion (almost 70%) in September, $170 billion of which ended up as an un-sterilized liquidity injection into the financial system - also unprecedented any way it is measured.

It is almost as much as the entire U.S. banking system created in the 12 months ending August 2008. It is about 20% of the cumulative amount of reserves the Fed has directly injected into the banking system since its inception in 1913. In one month, the Bernanke Fed "printed" MORE money than the Greenspan Fed in its entire easing campaign from 2001-03 - on top of which the banking system created $1.5 trillion.

Let me be the first to tell you that this represents a deliberate and abrupt change in monetary policy.

The Fed is no longer sterilizing its liquidity injections by selling off assets - probably because it doesn't have any left. No one else seems to have caught on yet. The Fed is now printing with abandon, as literally as that can mean.

However, that isn't enough to convince the deflationists. They point out that banks aren't lending and that credit markets have frozen all over the world.

This is obviously true. However, it does not follow from this that there will be deflation.

Let me reiterate that first, whether deflation comes about or not (I think not), the financial crisis is deepening precisely because, up until last month at any rate, the Fed had not created much money, despite the massive rate cuts. This policy was unconventional and deliberate. It was aimed at gold.

It has produced many things that the Austrian business cycle theory would predict from the policy.

The enterprises that are failing today are boom dependent. They have come to depend not only on the artificial stimulus of lower interest rates, but on a continued expansion in credit and money supply.

Indeed, Fed and Treasury officials, the media and Wall Street all talk as if the economy could not grow if the banks were not producing new credit. For them, boom and growth are one and the same thing.

The market is telling you that some operations are uneconomical in the absence of this "stimulus."

If the Fed continued on its austerity program (with respect to the printing press), the dominoes would no doubt continue to fall. This would be a process of returning the economy to equilibrium, if you will.

That is the definition of a bust or recession. It would probably be deflationary.

The Fed wasn't aiming for that. It wanted only to put the squeeze on inflation expectations building in the gold and currency markets without undermining the boom. It was a bold and new move, but naive. But its actions can only suggest that it is realizing this, and is not prepared to do what is right - nothing.

Lending strikes are not new. They are typical at the height of a crisis.

The Fed has published data on reserves only up until the third week of September, so it does not yet reflect the $170 billion net increase in reserves created by the Fed through the entire month, as I had reported last week. However, up to Sept. 24, the Fed created some $84 billion in reserves, while the figure for total reserves increased by $67 billion (from $44 to $111 billion) in the same period.

Excess reserves, meanwhile, increased by about the same amount.

Don't get caught up in the numbers. These facts essentially support the view that banks aren't lending out those new reserves. However, this fact is neither new nor typically long lasting.

U.S. depository institutions are required to have about 10% of their checkable demand deposits at the Fed as reserve. This amount peaked at a little over $60 billion in the mid-'90s, declined to about $40 billion by the end of the century and has hovered around that number ever since, as if inflation did not exist. It pales in comparison with the more than $1.5 trillion in reserves that the Fed has pumped into the banking system in its entire 95-year history or the $4-5 trillion in deposits that the U.S. banking system has created on top of that in the same period (even after accounting for deposits destroyed).

This is leverage, but the Fed, not the stock market, controls the denominator.

The reason that total reserves have been shrinking has to do with reserve requirements.

Although savings deposits are often checkable in practice and can be accessed by debit cards, banks are not required to keep reserves against them. Therefore, banks like to sweep (and create) as many of these deposits as possible into the savings categories.

That's why there is an upward bias to the underlying trend in the ratio of excess to total reserves. It does not reflect an increasing tendency for bankers to restrict lending voluntarily, but likely understates the inflation in reserves.

But while the figure on total reserves may have become obsolete and lost much of its relevance, big changes in the data are always important and shed light on things.

Today, the Fed is opening new windows through which to transmit policy. It can inject liquidity directly into money markets, and now commercial paper markets. It can lend directly to primary dealers. It can buy mortgages. It can pay interest on deposits, which will have two effects: exposing the hidden reserves (above) and luring money into the Fed. The latter is deflationary, but the interest payments are inflationary, if "unsterilized."

At every crisis that is bigger than the last, the deflation argument is always compelling. But it is fundamentally misguided if it is related to the idea of asset deflation or deleveraging. These concepts are not interchangeable with deflation.

Deflation, for instance, hasn't occurred since 1933, but deleveraging and asset deflation have, often - last in the 2000-02 bear market, and even as the Fed and banking system created a bunch of money.

Banks don't make money on the interest differential from lending out other people's deposits. They make money by lending out more than they take in… by "creating" deposits (i.e., inflation).

This is what a fractional reserve banking system does. It will lend again once it is confident that the central bank is making funds easily available and stands ready to bail banks out. By not printing until last month and letting Lehman go, the Fed sent out mixed messages that it is only now clearing up.

Abolishing the Fed would be a great idea.

Your freedom would be secure. Recessions would be gone. Governments would not be able to increase spending without immediate retribution. Growth and equality would become synonymous.

Crazy?

Not really. It's basic economics.

However, it appears somewhat utopian given the public's attitudes about the market and politics.

Most of the world, led by its political leaders, believes that the economic crisis was caused by greed and excess in the private sector, that the market is inherently unstable or that deregulation was the culprit.

Even some Austrian School authors blame the repeal of Glass-Steagall - the New Deal-era legislation that prohibited bank holding companies from owning nonbank financial firms or competing with securities and insurance companies - for the crisis. That's ironic for reasons I won't get into here, but it is a qualified charge - meaning deregulation is a good idea only if the central bank didn't exist.

I personally don't agree.

Still, people by and large do NOT see monetary and fiscal policy as interventions causing disequilibrium.

They see them as offsetting and stabilizing institutions - safety nets and tools of economic and social management - as they were supposedly envisioned.

For this reason, I posit, central banks and governments do not have the political will it takes to do nothing.

The change in Fed policy last month proves precisely that, which is why gold should soar.

I believe the markets are wrong again to perceive a deflationary outcome. It is an entirely different monetary system than existed in the 1930s, when the Fed could not simply print up reserves.

Deleveraging and asset deflation are not bearish for gold, as they don't necessarily imply a contraction in money supply, and rarely have. They may be bearish for gold stocks, but they are bullish for gold prices, because they are the very factors that motivate the near-certain cries for new credit (or more money) arising from a bad understanding of the true causes of the crisis. They are not new and are ultimately dwarfed by the next crisis.

But maybe the deflationists will be right about the behavior of banks this time. They have been wrong at each point in history when the economy faced a crisis caused by inflation. The thymological (historical) experience is that when the Fed inflates, the banking system does soon after. The Fed has never inflated in one month as much as it did in September. So the odds are against deflationists.

Indeed, the money supply could grow 25-50% in less than a year if that liquidity isn't taken back.

Ultimately, though, both the prior boom and the bust can be explained wholly by the Fed's specific policies. As will the next boom… in gold mining!

Good trading,

Ed Bugos
for The Daily Reckoning

Editor's Note: The above was taken from the latest issue of Gold & Options Trader. To read more, click here.

Before starting up Gold & Options Trader, Ed comes straight from the North American heart of the gold market - Vancouver's Howe Street. During the nasty commodity bear market in the '90s, Ed still guided his clients to gold profits in Argentina Gold and Arequipa, both of which became buyout bait for Barrick. He also founded the "Bugos Gold Stock Index" which included no more than 10 stocks at any time.

-- Posted Wednesday, 15 October 2008 | Digg This Article