-->Of Bombs And The Bond Market

The Daily Reckoning

Ouzilly, France

Wednesday, 20 August 2003

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*** Bankruptcies hit new world record... but more to come!

*** Dow up... housing starts at 17-year high...

*** Hip hotels go belly up... surprise, surprise - it rains!

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We refer frequently to the 'Dollar Standard system.'
Readers accuse us of harping on it. Some think we are
obsessed. And it's true: the world's monetary system haunts
us like an unsolved murder.

Most people would rather sit through a joint-session of
Congress than have to hear about it. But for the benefit of
new readers and the dismay of habitual ones, we harp on the
Dollar Standard again today.

Who cares about the world's monetary system?

Reading the paper, a man first turns to see if his stocks
went up. Then, he turns to the sports page for excitement
or to the editorial page for laughs. But behind nearly
every headline, in the financial section at least, is a
salacious crime. The freakish monetary scheme known as the
'Dollar Standard' system did not come into being on its
own. It was put into place, like a pliable crony, in 1971,
after the Nixon Administration gave 'the VIP treatment' to
the Bretton Woods system. [Faithful readers will recall,
'the VIP treatment' was Idi Amin's code for killing
someone.]

"China posts record export surge," reports the BBC. Thank
the 'Dollar Standard system.'

"Personal bankruptcies hit new world record," the NY Post
tells us. 1.6 million people have declared bankruptcy in
the last 12 months. That, too, is a consequence of the
'Dollar Standard system.'

"U.S. trade deficit reaches nearly $1 million per minute,"
says the Daily Reckoning. Again, courtesy of the 'Dollar
Standard system.'

The money supply doubled since 1995, the Mogambo Guru told
us on Monday.

Debt levels reach new records. Housing starts soar. U.S.
stocks sell at 33 times earnings.

All the major financial stories, if they were followed by
an energetic newshound, could be trailed back to Nixon's
crime and the 'Dollar Standard system.' Of course, today's
reporters can't be bothered to trace the clues. They know
readers aren't really interested in what's behind the news;
they just want the lurid details from the crime scene:
stocks are up 25% so far this year - what more do you need
to know!

And yet, the biggest story never told will come to light
some day. The Dollar Standard system seemed like great
thing a few years ago! Under Bretton Woods, when a nation
ran a trade deficit, it was expected to settle the
difference in gold. This meant that nations had to sell
about as much as they bought, or they would soon be out of
gold and unable to buy more. No wonder central bankers
looked the other way when Nixon put a gun to Bretton Woods'
head. The new Dollar Standard removed the limits; suddenly,
Americans could spend far more than they could afford... for
years and years... and central banks could settle their
accounts with dollars which were infinitely abundant,
rather than gold, of which there never seemed to be quite
enough. The dollars piled up in foreign central banks.
Instead of redeeming them for gold... they were used to bid
up prices of stocks and bonds all over the world. What
could be nicer?

If only it would last forever!

But such is the world we live in that nothing lasts
forever... and certainly not an international monetary
system based on fraud and robbery. America is supposed to
buy nearly all the world's excess production with I.O.U.s
it never expects to pay off! Someday, those I.O.U.s will
become worthless, and the whole system will blow up.

In the meantime, we harp and watch the dollar. When it
goes, it all goes: stocks, bonds, real estate... and as many
as 20 million bankrupt Americans. (More on Friday... if you
can stand it... )

And now, the latest news from Eric Fry in New York:

-------------

Eric Fry in Manhattan...

- The Dow added 16 points yesterday to 9,429 and the Nasdaq
Composite jumped 1.2% to 1,761. Bonds also gained ground,
as the 10-year Treasury yield declined by 8 basis points to
4.38%.

- Stock market bulls and armchair economists cheered
yesterday's report from the Commerce Department that
housing starts soared 1.5% in the month of July - a new 17-
year high."We see in our markets a high degree of traffic
and optimism," Laurence Hirsch, chairman and chief
executive officer of Centex Corp., said in a television
interview with Bloomberg News.

- Perhaps, but we see a less comforting augury in the
housing-starts tea leaves... Maybe the robust housing
starts number are a sign of economic excess, rather than
success. Might the nation's homebuilders be committing the
cardinal blunder that most investors commit: extrapolating
the bullish recent past into an eternally bullish future?
Might homebuilders be caught up in the gold-rush mentality
that every financial bubble engenders?

- Maybe homebuilders are throwing up record numbers of
'spec houses' at precisely the same time buyers are
retreating from the market. Building permits were also
continuing to hover at very lofty levels. Single-family
building permits edged down at 0.3 percent to a 1.423
million annual rate from June, which saw the highest pace
since at least 1960, when monthly records started.

- But perhaps the homebuilders are right to expect a
rebounding economy to provide a steady stream of
prospective homebuyers. Certainly the stock market, bond
market and commodities markets - like groupies crowding
around a stage door - are all expecting a sexy economic
recovery to burst through the door at any moment.

- So giddily, yet confidently, does the hot little stock
market await the dashing economic recovery, that is sells
for 35 times earnings. The S&P 500 has gained more then 25%
since last October. What's more, cyclical sectors, in
particular, are doing well.

- The bond market - which would be the stock market
groupie's boyfriend of our metaphor - also awaits the
economic recovery... with a sense of dread. The bond market
sulks and mopes, knowing that a recovery will bring it
nothing but more pain.

- Meanwhile, the commodities markets have been standing on
their tippy toes - straining to see a glimpse of economic
growth. The Reuters-CRB Futures Index, which tracks a
basket of oil, metals and other commodities, has gained
nearly 10 percent from a year ago. At the same time, gold
prices have surged 16 percent and crude has gained 12
percent.


- And yet, despite the certitude with which all markets
await the recovery, the recovery has failed to appear... so
far. If we are to trust the markets' collective foresight,
as well as the leading indicators produced by various
government agencies and think tanks, 4% GDP is a 'lock' in
2004. But if we are to look around us at the coincident
indications of economic vitality, 4% GDP growth next year
seems like a fantasy... and perhaps a delusional one at
that.

- We certainly hope the markets are correct - that an
economic recovery will bound through the back-stage 'EXIT'
door at any moment, to the delight of its giddy fans. But
maybe the markets are simply 'on drugs.' Maybe the Fed's
months-long easy money fix is the ONLY thing that is
actually exciting the financial markets.

- And after the fleeting monetary buzz wears off, our
financial market groupies may well return to the suburbs -
metaphorically speaking - never having caught a glimpse of
the elusive economic recovery after all. We wouldn't rule
out this disappointing possibility... mostly because signs
of the bust still abound.

- Remember those hip 'boutique' hotels that popped up
during the late 1990s? Well, one the very hippest of the
hip hoteliers was Ian Schrager, operator of the oh-so-
trendy Mondrian Hotel in Los Angeles, the Delano Hotel in
Miami's South Beach, and the Paramount Hotel here in
Manhattan. But... oops!... what's this?!... Mr. Schrager's
hipster empire is short of cash?... Wow!... how unhip is
that?

-"Ian Schrager's Clift Hotel filed for Chapter 11
bankruptcy protection last week," the New York Post
reports,"as the hotel impresario struggles to restructure
mounting debt. The Clift in San Francisco is just one piece
of the Schrager Empire that is crumbling under slowing
tourism and increased competition from rival hoteliers. Ian
Schrager Hotels is saddled with some $355 million in debt
piled on during an expansion in the 1990s when business was
good."

- If Schrager can simply hang on until the next once-in-a-
lifetime financial market boom, he'll come out smelling
like a rose.

-------------

Bill Bonner, back at Ouzilly...

***"I couldn't believe it," said Pierre yesterday.

"I went to the mayor's office to try to get the situation
with the road fixed. You know, they stupidly put up 'Do not
enter' signs on both ends of the road so people couldn't go
either way. It was supposed to be 'One Way Only'. Of
course, we local people just ignored the signs. But the
visitors had no idea what to do. There was no way to get
across the bridge.

"Meanwhile, they spread the word that we couldn't water our
gardens anymore because the commune was low on water
because of the drought. So all my vegetables are drying up.

"Well, I went over to the mayor's office to straighten out
the road problem and what do I see... they were watering
flowers right in front of the mayor's office!
Unbelievable..."

*** But this morning, the weather changed.

"A clear liquid is falling from the sky," said a neighbor
this morning. After months without rain, people have
forgotten what it looks like.

"It's not much, but it's a start."

*** Gold gained $3.10 yesterday, putting it back over $360
an ounce. We were hoping it would fall below $350, so we
could buy more.

Gold is on more than our minds, lately... it is the star
attendee of the 2003 New Orleans Investment Conference.
This year marks the Conference's 30th Anniversary, and
everything planned seems to have taken on a golden aura.
Richard Russell, Jim Rogers, Rick Rule, Martin Wiess,
Robert Prechter and quite a few others have already agreed
to uphold its gilded tradition.

Yesterday, we advised you that we would also be speaking,
as will our New York editor, Eric Fry. Addison Wiggin of
our worldwide Paris HQ will be present as well... free
copies of our book in hand to distribute to the first 200
to sign up ["Financial Reckoning Day: Surviving the Soft
Depression of the 21st Century" is due out this September].

We urge you to join us, if you can. (New Orleans over
Halloween, no less, oh là là):

The 2003 New Orleans Investment Conference
http://www.oxfordclub.com/conferences/neworleans2003/home.cfm?id=2

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The Daily Reckoning PRESENTS: Could bonds resume their 22-
year bull market and confound the consensus? Not likely,
says Marc Faber.


OF BOMBS AND THE BOND MARKET
by Marc Faber

"Get your chips into play!"

So spoke Larry Kudlow, of CNBC fame, in a recent"Cramer
and Kudlow" show. However, what Kudlow failed to specify is
precisely on which number or color we should place our
chips.

I have recently taken a negative view about bonds... despite
the almost universal consensus that bond markets around the
world had reached a bubble peak and would from now on
decline. The so-called 'reflation trade', which most
strategists are advocating, implies that the selling of
bonds and the purchase of equities is the way to play of
the day.

Recently, however, I received a study by Ray Dalio and
Jason Rotenberg of Bridgewater Associates, an institutional
economic service I highly recommend, which pointed out that
whereas the twin deficits - the budget deficit and the
current account deficit - exploded in the period from 1983
to 1987, and in the process weakened the U.S. dollar, bonds
continued to rally from their secondary lows in 1984 (the
major low was reached in September 1981) until 1987.

Bridgewater doesn't buy the argument that the present
bulging twin deficits, each of which will soon reach around
5% of GDP (a record, I might add), is necessarily be
bearish for bonds. The Fed has the means to create
sufficient liquidity to support bond prices and simply let
the dollar slide in order to make the necessary
adjustments.

Since I religiously read the research papers published by
Bridgewater Associates, I did some thinking about whether
bonds could resume their 22-year bull market and confound
the consensus, while the dollar weakened much further. In
the process, I discovered some important fundamental
differences between the present situation and the economic
conditions that prevailed in the 1984-1987 period, which
permitted the bond market to rally while the dollar was
tumbling.

First, when bonds began to rally in the fall of 1981, they
had completed an almost 40-year bear market. In addition,
the 1983-1984 renewed weakness in bond prices saw the yield
on government bonds spike up once again to over 14%,
whereas inflation had by then already declined to less than
4%. Thus, in 1984, bonds had an unusually high real yield,
as the investment community still believed that inflation
would reaccelerate at any time.

In other words, in those days, inflationary expectations
were extremely high, because investors were conditioned by
the highly inflationary 1970s during which it appeared that
there was no end in sight to rising commodity prices and
inflation rates.

However, when commodity prices continued to decline between
1984 and the summer of 1986 and the CPI declined to around
2.5%, while at the same time the Producer Price Index was
briefly deflating, bonds staged a huge rally, bringing
yields down from above 14% to less than 7.5%. Now, however,
it seems to me that the very high inflationary expectations
of the early 1980s, which led to record-high real interest
rates on long-term bonds, have been replaced by widespread
complacency about future inflation rates and, in fact, fear
about outright deflation.

Another point that should be mentioned is that, whereas
until 1987 the U.S. had a positive net investment balance
(it owned more assets abroad than foreigners owned assets
in the U.S.), this has today been replaced by a negative
investment balance, which amounts now to around 25% of GDP
and is currently growing by around 5% of GDP.

Thus, today, the ownership by foreigners of U.S.
Treasuries, corporate bonds, and equities is more than
twice as large as a percentage of GDP as it was in 1984 -
not an insignificant point when appraising the future of
bond prices amidst a U.S. dollar bear market, as
Bridgewater seems to forecast. It is, to my mind, doubtful
that foreigners will continue to increase their already
very significant exposure to U.S. bonds, which are now
offering very low yields, if the dollar is going to weaken
much further.

Another point I believe to be relevant when comparing the
1984-1987 bond bull market and the present situation is
that, at the time, Paul Volcker was Fed chairman. By
contrast, we now have monetary policy makers such as Alan
Greenspan and Mr. Bernanke at the helm, who are much more
likely to tolerate higher inflation rates than Paul Volcker
would ever have done.

Lastly, it should not be forgotten that crude oil prices
tumbled between 1985 and 1986 from more than US$30 to less
than US$12.

Now, I am not suggesting that oil prices couldn't decline
once again, but a decline of this magnitude seems highly
unlikely given both the rising oil demand we have in Asia
and how badly the occupation by the coalition forces is
going in Iraq, which will be unlikely to lead to
significant oil exports from Iraq. At the same time, the
cost of the occupation is almost certain to increase the
U.S. fiscal deficits for some time to come.

I have been highly skeptical about the invasion of Iraq. I
have subsequently received several hate emails for having
the audacity to question the war, so I have decided to
refrain from making any additional comments. I am, however,
indebted to my friend Professor Marvin Zonis, a brilliant
international political analyst, for allowing me to reprint
some of the views he expressed in a recent report entitled
"Terrorism Alert: 'Waste Deep in the Big Muddy' of Iraq".
Under the subtitle,"A Guerilla War in Iraq", he writes:

"Before the U.S. war against Saddam Hussein, I predicted
that the outcome would, eventually, resemble the fate that
befell the Israelis after their invasion of Lebanon in June
1982. The Israelis had liberated Lebanon from its near-
total control by the PLO, which had fled to Lebanon after
losing its war against King Hussein in Jordan in 1970.
After a rapid and total Israeli military victory in the
summer of 1982, Yasser Arafat and his PLO fighters were put
on freighters in Beirut and exiled to Tunisia. But in 1983,
hundreds of U.S. and French Marines were killed in separate
terrorist bombings in Beirut and the U.S. pulled out.

"By 1986, the Israelis had fled from Lebanon, unwilling to
sustain the low level of casualties that were constantly
inflicted on their armed forces. Before the U.S. war
against Saddam Hussein, I suggested that the Iraqis would
turn against the U.S., as the Lebanese had turned against
the Israelis, seeing them as occupiers rather than
liberators and that a turn against the U.S. would come to
be one way the Iraqis could generate a national identity
and create a unified Iraq. The turn against the U.S. has
already occurred. (Like all other processes in our age, the
transformation of the U.S. from liberators to occupiers
occurred more quickly than was conceivable two decades ago
for the Israelis in Lebanon.)

"The most dangerous part of this story, however, is not in
Baghdad, but in Washington. The Bush administration appears
to be in a state of denial about the seriousness of the
U.S. position in Iraq. What has become increasingly obvious
is that the deaths of American soldiers and the looting in
Baghdad and Basra are the product of organized opposition
to the U.S. occupation. The U.S. is now in a guerilla war -
a low-intensity conflict - in Iraq. The killings of
Americans are not the product of disgruntled, lone, Saddam
loyalists. They are the product of determined opposition to
the U.S.."

According to Zonis, the violent opposition appears to be
largely the work of Sunnis, but the Shiite areas of Iraq
are apparently also increasingly restive, complaining that
U.S. officials promised that Iraq would be turned over to
the Iraqis as soon as Saddam was overthrown. And commenting
on President Bush's response to the rising casualties,
Marvin (not me, although I agree with his views) writes:
"President Bush displayed his usual macho style [recently],
when he told reporters, 'There are some who feel like
conditions are such that they can attack us there. My
answer is: Bring them on. We have the force necessary to
deal with the situation'. But by all accounts, however, the
U.S. does not have the force necessary to deal with the new
terrorism."

Zonis then explains that before the start of the war,"Army
Chief of Staff, General Eric Shinseki, argued that hundreds
of thousands of troops would be necessary to stabilize a
post-Saddam Iraq. Secretary Rumsfeld and Deputy Wolfowitz
slammed the General (who has now been retired from the
armed forces) on the grounds that his estimates had nothing
to do with Iraqi realities. The word from Baghdad is that
U.S. administrator Paul Bremer has asked for a substantial
boost in U.S. troop strength. The request has been denied
by the Pentagon."

According to Zonis,"armed resistance to the U.S.
occupation of Iraq is likely to grow and not diminish as
the U.S. fails to restore vital services - electricity is
still being delivered to Baghdad for fewer hours per day
than Saddam supplied - and as Sunnis are energized by a new
crop of young hot-headed clerics. That the U.S. is involved
in a classic guerrilla-type war is, incidentally, also the
opinion of the U.S. military's new commander in Iraq,
General John P. Abizaid, whose views seem to be in sharp
contrast to earlier statements by Defense Secretary Donald
Rumsfeld."

Now, if the U.S. is indeed engaged in a guerrilla war in
Iraq (and by all accounts, it certainly looks that way),
victory won't be easy. I remember well my meeting with a
French member of the Foreign Legion on the Island of
Corsica in the 1960s. He had fought in 1954 at Dien Bien
Phu in Vietnam, and served during the Algerian uprising
prior to Algeria gaining independence in 1962. According to
him, his regiment was relieved when they left Vietnam.
Every legionnaire was looking forward to being stationed in
Algeria, which they thought would be like a paradise when
compared to the tough campaign and eventual hellish defeat
they had experienced in Vietnam.

However, this proved to be an illusion. According to him,
the Algerian war turned out to be far worse than Vietnam,
because the French troops in Algeria never knew who was
friend or enemy and, therefore, incurred tremendous
casualties in continuously recurring ambushes, acts of
sabotage, and raids on their camps.

The problem with guerrilla wars is that the enemy isn't
visible, and so, unless the local population almost
unconditionally supports the occupying forces, guerrillas
can easily hide among and seek support from the local
population. Claus von Clausewitz describes in his classic
work"On War" (first published in 1832) that any"attack
which does not lead to peace must necessarily end up as a
defense. It is thus the defense itself that weakens the
attack. Far from this being idle sophistry, we consider it
to be the greatest disadvantage of the attack that one is
eventually left in a most awkward defensive position."

This is exactly where the coalition forces find themselves
now - in a very awkward position. Not only do the minority
Sunnis oppose the occupation, since in a reconstituted
Iraqi government they would be outnumbered by the Shiites,
but it is likely that some more radical elements of the
Shiites with the support of Iran will fight the occupation,
which, according to some well-placed sources, will lead to
an American attack on Iran sometime early next year. In any
event, it is doubtful that the occupation will be over
soon.

While it is unlikely that the tactics employed by the
Iraqis will lead to a"Teutoburger defeat", which, when in
AD 9 the German leader Arminius lured the Roman legions
into the Teutoburger forest, resulted in the liquidation of
three Roman legions under the command of Publius Quintilius
Varus (the emperor Augustus is quoted as having exclaimed,
"Varus, Varus, give me back my legions!"), a costly, drawn-
out war with heavy casualties, along the same lines as the
Algerian war, should not be ruled out. I might add that
Arminius is widely regarded in Germany as a hero who,
according to the Roman historian Tacitus, was
"unquestionably the liberator of Germany", since the Romans
were subsequently forced to retreat south of the Rhine and
behind the Limes and Danube rivers. This is the reason why
Germany, unlike Gallia (France), was never Romanized.

It also goes to show that the so-called Pax Romana, which
reached its zenith under Augustus, is more a myth than
reality, since Roman legions were continuously engaged in
costly wars in the Empire's provinces.

The situation into which the coalition forces have boxed
themselves in Iraq is potentially far more serious than the
financial markets are giving it credit for. It could, if it
deteriorates, not only have implications for the budget
deficit and President Bush's chances of being re-elected,
but also for geopolitics, since one can safely assume that
both the Russians and the Chinese (who are becoming
increasingly dependent on Middle Eastern oil) have little
interest in seeing the Americans succeed in their endeavor.

As a result, I believe that the risks in U.S. financial
assets remain high and that the U.S. dollar, U.S. bonds,
and U.S. equities are vulnerable to a large number of
potential negative factors, which could disappoint
investors, if not in the second half of this year, then in
2004.

So, as Larry Kudlow suggested, where should investors get
their chips into play?


Regards,

Marc Faber,
for The Daily Reckoning