The Privateer 2010 Volume - Late July Issue - Number 658

THE PRIVATEER:
The Private Market Letter
GLOBAL REPORT
For The Individual Capitalist.

Published since October 1984.

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(reproduced with permission)
THE SECOND COMING
“... everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.”
WB Yeats - The Second Coming - 1919
Our era is much more mundane than that. What is now coming towards us
is being described by the mainstream press as the “double dip” or the
“W-shaped” recovery. On July 21-22, Fed Chairman Bernanke was in the
hot seat for two days in Washington DC giving his semi-annual monetary
policy report to the US Congress. In the lead in to his testimony, Mr
Bernanke was being advised to appear concerned, not desperate. That type
of advice has been making the rounds everywhere in recent weeks as
governments and central bankers confront economies which are weakening
right in front of their eyes.
In the US, the deficit for the fiscal year which ends on September 30 has
now officially hit the $US 1 TRILLION mark. As of July 21, the
Treasury’s “debt to the penny” stood at $US 13.246 TRILLION. It began
fiscal 2010 at $US 11.910 TRILLION. That gives a rise in Treasury debt
since September 30, 2009 of $US 1.336 TRILLION - and counting.

Forget The Talk - Watch The Action:

SUBSCRIPTIONS:
In AUSTRALIAN Dollars
Annual US Treasury debt increases doubled every year from 2007 to 2009.
Trial: 5 issues (once only) $A 25 Over that period, they rose from about $US 550 Billion in the year ending
Six-Month: 12 issues $A 100
Annual: 25 issues $A 180 on September 30, 2007 to just under $US 1.9 TRILLION in the year
Two-Year: 50 issues $A 300 ending on September 30, 2009. To keep that “string” going, the debt
Australian residents: Please increase this year would have to be almost $US 4 TRILLION. That is
add 10% for GST NOT going to happen. On its present trajectory, Treasury debt this year
will increase by less than it did in fiscal 2009.
Subscribe at our website:
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Given the fact that the increase in Treasury “debt to the penny” over fiscal
2009 was $US 1.885 TRILLION, it is clear that official US federal
government spending has hit the proverbial wall. Barring a huge new stimulus package and/or a new bout
of Fed “quantitative easing” between now and the end of September, the US federal government is on
track to officially borrow less this year than they did last year.

That leaves the global economy with a very nasty problem indeed. The dwindling private sector remains
as moribund as ever. Even in China, spending has slowed down markedly in recent weeks. The toxic
assets which have been hauled off the market by central banks to preserve commercial banking
“solvency” remain quarantined. To subject them to the not very tender mercies of market pricing would
be to instantly expose almost every major national banking system in the world as being insolvent.
The Privateer - Number 658 Page 2

Giving Up The Political Future For The Present:

Democrats in the US House of Representatives have approved an “enforcement resolution” rather than a
full budget for the fiscal year that begins on October 1, 2010. They have chosen to do this despite the fact
that it limits their ability to choke off debate over any legislation which impinges on the budget. By
choosing an enforcement resolution, the Democrats lose their ability to limit debate in the House. Far
more important, they lose the tool of “reconciliation” which allows the bill to pass the Senate with a mere
51 votes rather than the 60 votes needed to prevent a filibuster from the opposition.

This is a choice that the initial Democratic majority in both Houses of the US Congress would not even
have considered in the early days of the Obama administration. But those “yes we can” days are long
gone. With the mid-term elections in November getting ever closer, the Democrats are terrified of being
seen to have voted yes to the new budget, which would of course add to the already astronomical deficit.
In a desperate attempt to minimise their losses at the mid-term elections in November, they have given up
their most powerful means of passing ANY legislation which is at all controversial or opposed by their
Republican (and potentially Tea Party) opposition. Right now, that means any legislation which adds to
the debts and deficits of the US government. The US administration is loathe to embark on a program of
“austerity”. The US Congress is terrified of the consequences of NOT doing so.

Reality Is Looming:

Over the weekend of July 10-11, the two heads of President Obama’s national debt commission attended
a meeting of the National (state) Governors Association. The Democrat co-head of the commission,
Erskine Bowles, told the meeting that the Treasury’s debt was “like a cancer” and went on to insist that
“it is truly going to destroy this country from within”. Strong stuff indeed. The commissioners flatly
stated that three programs - Medicare, Medicaid and Social Security - consume ALL current US federal
revenue. EVERY other government expenditure - up to and including servicing the current debt and the
“off budget” wars in Iraq and Afghanistan - is being financed by foreign buyers of Treasury debt.

Originally, this commission was to have put forward recommendations for increasing taxes and/or cutting
spending which the US Congress, by law, HAD to publicly debate. But the original bill to set up the
commission was watered down to the point where instead of being an act of Congress, it was formed by
an executive order by Mr Obama. This has two “advantages”. It means that the commission does not
have to present their findings until AFTER the mid-term elections. It also means that the Congress does
not have to implement ANY of the recommendations nor even debate them if they choose not to.

The Democrats in Congress are slowly coming around to the stark reality that they cannot govern with an
accelerating deficit, but they don’t want to actually CUT spending. The Republicans are dead set against
any raising of taxes. Most of the rest of the world has now publicly stated that they will both cut
spending and raise taxes. Some nations, notably former “East Bloc” and “Club Med” nations, have had
no choice in the matter. Other nations, notably the UK, have recently installed new governments who
were elected on their pledges to address out of control government debt and deficits. Canada has raised
rates. So has Australia, which has also raised taxes. Inside the US, state spending cuts have become
draconian by any prior standard. In the face of all this, the US federal government stands all but
paralysed in the light of the oncoming juggernaut of a sovereign debt crisis.

Even The Fed Admits It:

On July 14, the Fed released the “minutes” of the June 22-23 FOMC meeting. Buried within all the usual
“Fed-speak”, one line was enough to sent the markets reeling. The line? “The committee would need to
consider whether further policy stimulus might become appropriate if the outlook were to worsen
appreciably.” What “further policy stimulus” could the Fed fall back on? Well, to quote a 2002 speech
from Mr Bernanke - “the US government has a technology, called a printing press.”
The Privateer - Number 658 Page 3

“If The Outlook Were To Worsen Appreciably”:

Here is the problem. The outlook HAS worsened appreciably. Everyone in the US, up to and including
Mr Bernanke, knows it. That is why Mr Bernanke said that the Fed was “prepared to take further policy
actions as needed” in his testimony to the Senate Banking Committee on July 21.

However, Mr Bernanke was not prepared to outline precisely what the Fed’s future game plan might be,
saying that he and his colleagues haven’t decided yet. He also devoted most of his testimony to the Fed’s
plans to exit from their stimulus measures - at some still undefined future point.

To continue the quote from Mr Bernanke’s 2002 speech on “deflation”, the government’s printing press -
“... allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the
number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can
also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices
in dollars of those goods and services. We conclude that, under a paper money system, a determined
government can always generate higher spending and hence positive inflation.”

Please note this carefully. Mr Bernanke made that speech more than eight years ago in early 2002. That
was before the US real estate bubble, before he became Fed Chairman in 2006 and before the GFC hit in
2007. Since he made that speech, Mr Bernanke has seen a full year of 1.0 percent official US interest
rates in 2003-04. Since becoming Fed Chairman in February 2006, Mr Bernanke has taken more “policy
actions” (including more than 18 months of keeping official US rates at ZERO percent) than all of his
predecessors combined. What has it bought him? Nothing but a bit of time and the prospect of a bigger
collapse than the one his policy actions postponed in late 2008.

A “Double Dip”?:

When Ben Bernanke was appointed Chairman of the Federal Reserve on February 1, 2006, the US
Treasury’s “debt to the penny stood at $US 8.183 TRILLION. Today (July 20), it stands at $US 13.246
TRILLION. In just under four and a half years, US federal government funded debt has increased a bit
more than $US 5 TRILLION or 62 percent. That’s an average annual increase of $US 1.125 TRILLION.

On top of this, there is the Fed’s balance sheet, stuffed full of financial paper which would not be sold on
any kind of “open market” at more than a tiny fraction of its “book value” - if it could be sold at all. On
top of this is the fact that in the US, in most of Europe and increasingly in Asia, nobody will lend on
anything which is not explicitly “guaranteed” by government. Talking about being ready for more
“stimulus” measures in the face of the fiscal and financial wreckage which has NOT been cleared away
(but merely hidden from view) by previous “stimulus” is surreal. It is like claiming that another jolt of
the electricity which is making the dissected frog’s legs move will bring the poor critter back to life.

The point is simple. The Fed says it is prepared to act as “needed”. Under Mr Bernanke, the Fed HAS
acted - to an extent never before approached. So have all the other major central banks in the world - and
most of the minor ones too. NONE of the debt problems which brought on the GFC (and all the previous
downturns and recessions) has been addressed, let alone resolved.

At the height of the first crisis of the GFC in September/October 2008, The Privateer headlined an issue
like this: “Who Bails Out The US Treasury?”. Since then, the answer has been the US Fed (with its
quantitative easing), foreign central banks and investors scrambling for “safety”.

Foreign central banks are creaking under the pressure. The latest Fed “TIC” (Treasury International
Capital) data shows that China’s holdings of US Treasuries fell to their lowest level in a year in May
2010. The Fed has not yet reimposed its quantitative easing, although more and more analysts are
clamouring for it to do so. And yet yields are STILL falling as fear grows over the “double dip”.
The Privateer - Number 658 Page 4

Record Low Interest Rates:

On April 5, the yield on two-year Treasuries hit a high for the year of 1.18 percent. It has been falling
ever since. By mid July, it had dropped to its lowest levels ever. New record lows were hit on July 15,
16, 20 and 21. By July 21, the yield on two-year Treasuries had fallen to 0.55 percent.

What is driving this renewed retreat into the “safe haven” of US Treasury debt is “The Second Coming”,
the marked slowdown of the US economy as measured by the government’s own statistics. At the same
time, the borrowing pace of the US government is slowing, simply because it could not possibly have kept
rising at the same pace it was in fiscal 2007 through 2009. Don’t forget, official deficits doubled every
year over that period. As stated earlier, another doubling this year would have required an official
Treasury debt increase of nearly $US 4 TRILLION. The government is predicting a $US 1.6 TRILLION
deficit by the end of fiscal 2010 on September 30. That falls a LONG way short.

It also makes a descent into another recession/depression in the US - and everywhere else - an absolute
certainty. An economy that lives by government “stimulus” will perish by government “stimulus”. There
have been no impediments to such stimulus for 40 years anywhere. This is because money is backed by
debt and nothing but debt and the issuance of debt by government is held to be cost free.

The lower short-term Treasury rates go, the more investors are deciding that a precarious “safety” in the
immediate future is preferable to a growing fear of financial chaos in the not too much more distant
future. Sure enough, as fears of a “double dip” have increased since April, short-term Treasury yields
have plunged. But for the first time in the fiat currency era, they are NOT plunging on the back of Fed
rate cuts. The Fed has been “pushing on a string” ever since it began to lower rates in September 2007.
That “string” ceased to exist in December 2008 when the Fed funds rate reached zero. For the first time,
the US is facing the PROSPECT of a recession with official rates already as low as they can go.

We Can’t Go On Spending Like This:

On July 19, one of the two major “establishment” newspapers in the US, the Washington Post, published
an investigative piece they titled - “Top Secret America”. This study looked at the immense US
government “intelligence gathering” structure which has blown out in the wake of 9/11.

The facts reported make for very sobering reading. “Intelligence services” (mostly related to the “war on
terror”) involve 1271 government organisations and 1931 private companies. Almost one million
Americans hold “top secret” security clearances. Since 9/11, 33 building complexes to house these
activities have been built all over the US. Combined, they occupy the equivalent of THREE Pentagons.
All of these organisations must be funded. Most of them have overlapping fields of “responsibility”.
There are billions of pieces of communication data collected daily and tens of thousands of intelligence
reports produced annually. Most of them overlap. Few of them are ever read - by anybody.

Then there are the “turf fights”. An agency called the Office of the Director of National Intelligence
(ODNI) was created in 2004 to oversee the entire effort. The director of this agency did not then and does
not now have clear legal or budgetary authority over US intelligence. The monster has run amok.

The report is interesting for two reasons. First of all the Washington Post is (along with the New York
Times) the major US newspaper outlet for the same US establishment which oversaw the development of
this behemoth in the first place. Clearly, some part of that establishment is getting cold feet. But far
more important than this aspect is the example of how ALL government departments grow over time to
overwhelm their creators. Every major department of all governments who “run” the economy of the
nation they govern begin in response to some perceived “need” of the people. The welfare state
“agencies” started this way, as did the “military industrial complex”. Ultimately, the sheer size,
complexity and expense of the operation overwhelms the nation it purports to “serve”.
The Privateer - Number 658 Page 5

The Ceremony Of Innocence:

If you flick back to page one, you will see that this headline is taken from the quotation with which we
began this section. Innocence needs no ceremony. In fact, in popular parlance, the phrase to “stand on
ceremony” means to insist on any action being accompanied by excessive formality or contrived ritual.

For well over a year now, the world has been inundated by claims that the actions taken by governments
and their central banks had saved the world from an economic fate worse than death. Economic “growth”
is ours and will always be ours as long as we go along to get along. For almost three years, those who
face the task of actually making a living by creating real wealth have been shrinking their horizons,
delaying or cancelling their plans for the future and hunkering down to cope with a dwindling standard of
living. In short, more and more people everywhere are striving to once again live within their means,
having no choice in the matter.

While all this has been going on, those whose self-professed mission is to “run” the economy have been
going in the opposite direction. Their message is unwavering and incessant. They proclaim that it is
possible to borrow our way to wealth. They assert that an “asset” is worth whatever was originally paid
for it and enforce that “worth” by never letting it be tested in the marketplace. They insist that present
prosperity can be paid for with future production - forever. They make all these claims as if they were
self-evident truths, to be doubted only by those who are not the “innocents” they want us all to be.

The Best Lack All Conviction:

If the public polls in the US (and elsewhere) are anything to go by, they are surely losing it with
increasing speed. There has not been a federal election in any major country over the past couple of years
where the “ruling” party has not been turfed out in favour of the opposition. Consumer confidence is
once again plummeting almost everywhere. In the US, the percentage of Americans who expect their
incomes to rise over the next twelve months has hit a record low. Consumer sentiment has hit its lowest
level since August 2009. In June, US consumer confidence posted its biggest monthly fall since October
2008 at the height of the Lehman panic. Seven in ten Americans do not think that the “recovery” ever
took place, saying that the US is still mired in recession and expecting it to get worse.

Finally, to an extent seldom matched in US history, Americans today are unsure of what they want to vote
for but vehement in what they want to vote against. All incumbent US politicians are facing an increasing
backlash. An unprecedented number of them, both Democrat and Republican, have not even made it back
onto the ballot for the mid-term elections in November.

Holding On Until November:

As far as their public policy is concerned, the US and Europe are now on opposing paths. Europe is
giving up or has already given up on the pretense that perpetual government stimulus via sovereign debt
creation can stave off what is so benignly referred to as a “double dip” recession. The US, by stark
contrast, continues to “consider whether further policy stimulus might become appropriate”.

While the US central bank does this, another government body insists that US debt levels are “truly going
to destroy the country from within”. The problem is that while the heads of Mr Obama’s “debt
commission” are saying these things, they are also saying that their chances of success in convincing the
Congress to do anything about this debt are “minimal, at best”.

Today, the “double dip” looms over everything. It was always inevitable, the only question was how long
it could be postponed by the “stimulus” which has prevented the “first dip” from turning into a swan dive
for the past year and a bit. The rest of the world is increasingly resigned to it. The powers that be in the
US profess they can still hold it at bay. Meanwhile, November remains a LONG way into the future.
The Privateer - Number 658 Page 6

INSIDE THE UNITED STATES

WHAT’S A POOR FED CHIEF TO DO?

On Thursday (July 22), Fed Chairman Ben Bernanke finished his semi-annual testimony to the US
Congress with an appearance before the Senate Banking Committee. As he no doubt expected, Mr
Bernanke was questioned on the further steps the Fed could take in the event of another economic
downturn. He began by pointing out, to the surprise of nobody, that none of the Fed’s remaining options
are “conventional”. He then went on to list them.

First, the Fed can stop selling some of the “toxic sludge” - mostly mortgage-backed securities (MBS) - it
has in its balance sheet. Currently, the Fed is sitting on about $US 1.3 TRILLION (face value) of this
paper. It could opt to hold it at a steady level or even increase it again. The problem with this approach is
that it would confirm a “double dip” and would have minimal effects on new borrowing anyway.

If renewed MBS buying was not enough, the Fed could re-start its “quantitative easing” program of
directly buying Treasury debt paper. This approach is already being talked up in the mainstream media
and has been nominated as the Fed’s most likely action by St Louis Fed President James Bullard. The
risk is that diffused global fears of sovereign debt risk would instantly focus on the US.

If both of these approaches are deemed too risky, the Fed could simply guarantee not to move its
controlling interest rate from its present 0.00-0.25 percent level for a specified (and probably long) period
into the future. That, sadly, would take monetary policy off the table entirely.

Finally, the Fed could open a new “lending facility” aimed at any sector of the economy it chose. Likely
candidates would be sectors which are facing great difficulty in borrowing. They include commercial real
estate or even state and municipal government. Again, the attendant risk is that the Fed would end up
trying to bail out EVERYBODY while losing control of both US interest rates and its own debt paper -
known in commercial circles as Federal Reserve Notes or, in more popular parlance, US Dollars.

Money For Nothing And Your Checks For Free!:

After almost six months of steadily increasing political angst accompanied by an ocean of “crocodile
tears”, President Obama was finally presented with his most cherished desire on July 22. Placed on his
desk was a bill which reinstates unemployment payments for millions of Americans. Individuals who
have been out of work for six months or more and whose unemployment payments were cut off on June 2
will soon be getting their “benefits” - including retroactive payments covering the period since June 2.

The extension of unemployment payments is about all that has survived from what was touted back in
February as Mr Obama’s second “stimulus package”. The new bill pushes these payments out until the
end of November - again - AFTER the mid-term elections. Already, the White House is signalling that
another extension will likely be sought then.

On the same day as the bill finally made it through the House (the Senate had passed it on the previous
day), the US Labor department reported that 464,000 Americans had begun to claim unemployment
benefits over the week ending on July 16. This is one of the biggest week-on-week rises so far this year.
Claims were far above “expectations” and rose by more than 8 percent from the previous week. Almost
seven million Americans have been out of work for six months or more.

In his Congressional testimony, Mr Bernanke singled out unemployment as the most “pressing challenge”
for the US economy and said that the Fed stands ready and able to return to crisis management - “if we
don’t see the kind of improvements in the labor market that we are hoping for and expecting.” Once
again, this is clear evidence of a desperate “holding policy” to get through the November mid-terms.
The Privateer - Number 658 Page 7

INSIDE CHINA

CHINA BASHING - OR - BITING THE HAND THAT FEEDS YOU

Cast your mind back for a moment to 2009, the year when China was praised to the skies for being the
global engine of “growth” while complying with the entreaties coming from the new US administration
that it concentrate on building up domestic consumption. Last year, China did both these things. It
embarked on a “stimulus” program which was nearly as big (in monetary if not per capita terms) as the
one that the new Obama administration was using to try to “kick start” the US economy. And it greatly
relaxed its controls on bank lending so that the Chinese people could start consuming more of what they
were producing. This, it was hoped by the US, would cut down on China’s massive trade surplus.

Now, here we are in the second half of 2010. Warnings are proliferating about a bursting Chinese
investment “bubble” - specifically in real estate but spilling over to encompass most sections of the still
growing Chinese economy. It seems that China can’t “win”.

Always looking for new fields of conquest, the US ratings agencies are casting an eye at the Chinese
economy. On July 14, Fitch released a report which said that Chinese banks were engaging in “complex
transactions” which hid the size and nature of their lending. Unearthing an even more heinous financial
crime, Fitch went on to accuse the Chinese government and its banks of masking a coming wave of bad
real estate loans. It seems that China is repackaging loans into investment “products”.

This is farcical. We wonder if these investment “products” have any resemblance to the US “products”
that Fitch and its fellow agencies were falling all over themselves to award AAA ratings to in the lead up
to the GFC. Even more hilarious, a British bank is complaining that there is “limited transparency” in
the complex lending practices of Chinese banks and in their relationship with the Chinese central bank. Is
there a major central bank in the world which has not made sure that the true nature of their lending
practices and those of their banks is as opaque as possible? Certainly, Mr Bernanke of the Fed has been
fighting tooth and nail to keep its relationship with US banks private to preserve its “independence”.

We Can Play This Game Too:

China is clearly getting a bit fed up with all the “pot - kettle - black” analyses of every aspect of its
economy that is flowing out of western (mainly US) economic and financial circles. They are certainly
not taking it lying down. Instead, they are hitting back - on a number of fronts.

An Oriental Ratings Agency:

It would seem that there are more than three (all US based) ratings agencies in the world. There is at least
one more, the Dagong Global Credit Rating Co. based in, of all places, Beijing. Following the lead of its
US counterparts, “Dagong” has decided to cast its eye over the world of sovereign debt risk. Having done
so, it has awarded the US an “AA” (two below top grade) rating. China (along with Germany, Holland
and Canada) gets an AA+ rating. The coveted AAA goes to Norway, Denmark, Switzerland, Singapore,
Australia and New Zealand.

In announcing its sovereign ratings, Dagong’s chairman said this: “The essential reason for the global
financial crisis and the Greek crisis is that the current international rating system cannot truly reflect
repayment ability.” What Dagong has done is to focus on the actual wealth creating capacities (and the
foreign reserves) of the nations it is rating. This is, of course, the only REAL “repayment ability”.

It is also the reason why the deputy governor of the Bank of China announced on July 23 that it is China’s
clear intention to “link” the Yuan to a basket of currencies, not just to the US Dollar. It is also why China
has so publicly backed both the Euro and the Japanese Yen in recent days.
The Privateer - Number 658 Page 8

INSIDE THE EUROPEAN UNION

STRESS TESTS - REAL AND IMAGINARY

The Europeans have held their bank “stress tests” and the results have been announced - on Friday
evening after the European markets were safely closed. As one would expect, the tests were met with
“relief” on Wall Street where the markets were still trading and which is grasping at any straw these days.

The reaction from the economic analysts, notably across the “pond” in the US, was not so benign. Don’t
forget that ever since last December, there has been a concerted effort from the US to make sure that the
focus of the “sovereign debt crisis” stayed squarely on Europe. That effort was ramped up still more
when the European nations, at least on paper, started taking heretical steps towards fiscal “austerity”.

The major objection we have seen to the European bank stress tests is that the risk of those same
European banks’ holdings of “sovereign debt” was inadequately tested. This is interesting, especially
since the US bank stress tests conducted in 2009 did not consider any “sovereign debt” problems at all.
Those tests were done before the sovereign risk crisis was kicked off - by the US ratings agencies.

The European stress tests DID take into account the possibility of large increases in interest rates and
servicing costs for European government debt, including the government debt of all the “Club Med”
nations. They even looked at the consequences of sovereign debt default, but only as it would affect what
are called the “trading books” of the banks. They did not apply the tests to the 90 percent of government
paper which the banks hold in their “banking book”. This is hardly surprising, since there is not a bank in
the world which would not be instantly insolvent if such a test was made. Don’t forget, government debt
paper is the underpinning for the entire system.

Trichet Gets Annoyed:

On July 23, the London Financial Times published an “op-ed” piece written by European Central Bank
(ECB) president Jean-Claude Trichet. The title of the piece was “Stimulate No More - It Is Now Time
To Tighten”. His message was blunt: “There is little doubt that the need to implement a credible
medium-term fiscal consolidation strategy is valid for all countries now.” The operative word is “now”.

The contents of Mr Trichet’s piece is predictable enough. Its timing, though, is quite interesting - for a
number of reasons. First, it was published the day after Mr Bernanke finished two days of testimony
before the US Congress in which he stressed the Fed’s willingness to go on “stimulating” if required.
There is also the fact that it was published in the British Financial Times, the premier financial outlet for
the British political and financial establishment. It is no secret in Europe or anywhere else that the new
British coalition government under Mr Cameron has announced some very “austere” steps indeed to get
the level of UK government debt under control. Neither is it any secret that at the recent meeting between
Mr Cameron and President Obama in Washington DC, the two agreed to disagree over their differences
regarding government austerity or continued stimulus. It seems the “special relationship” is under strain.

There is a long-term “tradition” that nobody rocks the boat when the US is in the midst of an election
campaign. This is especially true when the campaign is going badly for the ruling party. Mr Trichet’s
piece is being seen as a challenge to nations which have as yet done nothing concrete to rein in their
deficit spending. And in this respect, the US federal government would head any list one could make.

A REAL Stress Test:

Mr Liam Fox, the UK defence minister, stating that Britain can no longer afford its defence budget, is
talking about cuts in all areas including the 25,000 British troops stationed in Germany. Britain, like the
US, has had troops in Germany since 1945. A British pullout would be a HUGE precedent for the US.
The Privateer - Number 658 Page 9

AUSTRALIAN REPORT

BEFORE - AND AFTER - AUGUST 21

Australia’s federal election has been called. It will take place on August 21. The new Prime Minister,
Julia Gillard, who took the job a month ago on June 21, has decided to take advantage of what she hopes
is a “honeymoon period” which will last long enough to see her and the Labor party over the line.

In this election, one of the major parties has a female leader for the first time. On top of that, neither
leader of the two major contending parties has ever run for or been elected to the office of Prime Minister
before. On “precedent”, the Labor party “should” win this election. It has been a very long time since
there was a one-term federal government in Canberra. Even Labor’s Gough Whitlam, who lost the
famous election of December 1975 after his government was dismissed from office by the governor
general, won two federal elections. In Australian politics, an incumbent party which has only served one
term as the government is VERY seldom defeated on a second bite at the cherry.

As this issue of The Privateer goes to press, the “platforms” of both major parties have been conspicuous
by their absence. One would assume that there will be at least some indication of their political intentions
when the two major candidates meet for their first and only televised debate on July 25.

The Background To The Election:

In the eyes of the world, Australia is an economic exemplar. They are the major nation which has thus far
been seen to be the most unaffected by the GFC. Their central bank was the first G-20 nation to begin to
actually raise their official interest rates. They are the nation which has not suffered an official recession
(two consecutive quarters of “negative growth”) to date and are not expected to suffer it in the future. On
top of all that, they are one of the very few nations to which the upstart Chinese ratings agency (see our
Inside China page) has awarded a blue chip AAA rating. In the face of all this, the rest of the world was,
to put it mildly, startled when the former Labor leader and Australian Prime Minister Kevin Rudd was
ousted by Ms Gillard just over a month ago. In “normal” circumstances, the government of a nation
enjoying this level of international financial prestige would be seen as a “shoe in” to retain power.

Things are not as simple as that. Australians are no more trusting of the great “recovery” that
governments around the world are striving to sell to their electorates than are their American or European
counterparts. They have chosen to pay off debt to the extent they can rather than to spend. And when
they do spend, they are demanding BIG discounts before they unleash their credit cards. For many years,
the annual growth in retail sales has been around the 6.0 percent level. Over the past year, retail sales
have all but stalled, the “growth” figure is struggling to top the 1.0 percent level.

Most Australian retailers and economic analysts, when asked bluntly, will admit that it was only the $A
11 Billion in outright cash giveaways handed out by the Labor government that allowed retail sales to
grow in 2009. Since those giveaways were ended, “consumption” has all but ground to a halt.

While retail sales are languishing, the costs to retailers are inexorably growing. Across the board
increases in wages of a minimum of $A 26 a week cut in on July 1 along with higher government charges
and higher rents. On top of that, the Labor policy of forcing foreign shipping lines to pay local (VERY
high) wages when shifting cargoes between Australian ports has blown shipping costs sky high.

After August 21?:

The new government will be facing a world where economic “stimulus” cannot be indulged in much
longer. Of the two major parties, the opposition liberal/national coalition has long been the smaller
spender. If the Australian government is going to embrace “austerity”, they are the “least worst” bet.
The Privateer - Number 658 Page 10

THE GLOBAL MARKET REPORT

THE FED STANDS READY - FOR ANYTHING?

Amongst a lot of other interesting information contained in the recently released US Federal Reserve Z.1
“flow of funds” data, this snippet stands out: Over the past two decades, from the end of the 1980s to the
end of 2009, the rest of the world’s (ROW) holdings of US Dollar denominated debt paper has grown
from $US 1.9 TRILLION to 15.3 TRILLION. That’s an increase of 705 percent. It has also brought
ROW holdings of US debt from 60 percent to 108 percent of US GDP.

Don’t forget, government spending at all levels (most of it made possible only through borrowing) is
counted as part of any nation’s GDP.

Historically, no nation which owes more to foreigners than its annual economic production has ever
repaid that debt. It has either debauched the currency in order to “pay” with money of a vastly reduced
purchasing power or, more often, it has simply defaulted on its debt altogether. In reality, the US cannot
repay its foreign creditors, let alone its domestic ones. Mr Bernanke knows this, yet what is his
considered advice to Congress? “I believe we should maintain our stimulus in the short term.”

Perhaps, given his background and his reputation as a profound scholar of the 1930s depression, Mr
Bernanke HAS to believe this. But the rest of the world doesn’t have to believe it, and Mr Bernanke
knows it. What he wants the “ROW” to do is to go on acting as if they believe it.

A Foundation Of Financial Quicksand:

The rest of the world has very hard evidence based on fact as to what happens to a nation which gets as
deeply into debt as has the US over the past two decades. If markets are allowed even a pale imitation of
their normal functioning, interest rates in the nation in question soar and the nation suffers a period of
hugely depressed economic activity as it tries to put its fiscal house in order.

If markets are NOT allowed to function, interest rates may not rise or may rise to a much lesser degree
than they normally would. If that happens, the currency of the nation in question plummets, putting even
greater strains on an attempt to pay the foreign debt owing. The nation goes through the same depressed
period but it is made much worse and lasts much longer because the markets are hamstrung.

That is what happens to any “normal” nation. The two decades since the end of the 1980s have seen
every major nation on earth (with one exception) go through a more or less extended financial crisis at
some point. Currencies have soared and plunged right along with interest rates as international financial
agencies such as the IMF impose “austerity” measures which in many cases made the current ones being
suffered by Greece and its fellow “Club Med” nations pale into insignificance by comparison. All over
the world, investment markets have suffered accordingly. It is only since the start of the GFC three years
ago that this phenomenon became worldwide.

A “normal” nation is a nation which does not provide the world with its reserve currency and which is not
therefore capable of borrowing internationally in terms of its own currency. To take just one example,
Hungary has recently come back into the sights of the US ratings agencies. Hungary’s main problem is
the size of its foreign debt AND the fact that this debt is denominated in foreign currencies, notably in
Swiss Francs and Euros. The interest on this debt has not greatly increased, but the Hungarian currency
(the Forint) has plummeted against both the Swiss Franc and the Euro. That makes servicing, let alone
repaying, this debt a very difficult proposition indeed.

Since 1944, the US has never had this problem. That is what has enabled it to run both government and
trade/current account deficits without a break for half a century. Does the Fed stand ready for this?
The Privateer - Number 658 Page 11

How’s THIS For Market Action?:

Back in late April, when US and most other major global stock markets reached their 2010 highs, the US
ratings agency Standard & Poor’s lowered the sovereign debt of Greece to “junk” status. This escalated
the focus on global “sovereign debt” from what had been a growing concern to a genuine crisis. The
problem for Mr Bernanke and the financial US “powers that be” is that it also acted as the catalyst for the
current disagreement between those preaching “austerity” and those preaching “stimulus”.

The immediate reaction to the Greek debt downgrade was an abrupt downturn on major stock markets
along with a huge surge in the US Dollar, very similar to the one which had taken place in the wake of the
Lehman crisis in late 2008 - early 2009. As the US Dollar surged, so did Gold, in US Dollar terms.
Finally, and to make the perversity of this “market action” complete, the yields on US Treasury debt
(which had been falling gradually since early April) began to drop precipitously.

The rally in the US Dollar topped on June 8 at 88.47 points on the trade-weighted US Dollar index
(USDX). Gold topped two weeks later on June 21 with an all time high spot future close of $US 1258.30.
Since then, the USDX has given back almost all its April - June gains. It closed on July 23 at 82.65,
down 6.6 percent since its early June high. Gold closed on July 23 at $US 1187.80, down 5.6 percent
since its late June high. Gold has not given back its post April 2010 gains yet. To do that it would have
to continue to fall to the $US 1150 level.

On US and world stock markets, the post April downturn lasted a bit longer. The Dow, for example,
closed at its 2010 high on April 26, the day of the Greek downgrade to “junk” status. By July 2, it had
fallen to 9686, dropping 13.6 percent and suffering what the technical analysts call a “death cross” in the
process. A “death cross” refers to the 50-day moving average crossing below its 200-day counterpart.
The last such “crossing” came at the end of 2007 - two months after the Dow hit its all time high in
October 2007. The Dow has rallied back to its 200-day average over the past week, but the “death cross”,
which took place as the Dow hit its 2010 low at the beginning of July, remains intact.

(See the charts online which accompany this issue of The Privateer for the Dow’s “death cross”.)

US Government Debt:

At the state and municipal level, debt paper issued by the governments concerned has been suffering
badly this year. The most “budget burdened” US states (California and Illinois to take two examples) are
paying very high rates to borrow. While no US state has (yet) declared bankruptcy, many US
municipalities have. Municipal borrowers melted down at three times the “normal” rate over the first half
of 2010 with 35 bond issues defaulting. Yet the demand for US “munis” has as yet seen few signs of
slowing. One of the main reasons for this is that interest is exempt from federal taxation.

But elevate your sights to Washington DC and US Treasury debt and the situation is quite different. As
already mentioned, the fall of Greek sovereign debt to junk status in late April accelerated what had been
gradually declining Treasury yields. As already reported in the Global Report in this issue, the yield on
two-year Treasuries set all time lows on most of the trading days between July 15 and July 21. On top of
this, the spread between the yields on two and ten-year Treasuries has been narrowing, hitting a low for
the year on July 21. That means that the yields on longer-term Treasuries are falling even faster.

Mr Bernanke is adamant that the US government - the one in Washington DC - must keep on
“stimulating” for a while yet. He clearly sees no limit to the forbearance of both foreign and domestic
“investors” in Treasury paper. While the rest of the world recognises the danger - an excellent example
being Mr Trichet’s recent “op ed” piece (see Inside The European Union) - the Fed steadfastly refuses to.
There comes a point in every investment market at which what had been seen as the ultimate and only
form of safety flips to being the most dangerous place to park “assets”. Is the Fed ready for THIS??
The Privateer - Number 658 Page 12

The Last Central Banker Standing?:

It must be official because Mr Bernanke said it - to the Senate Banking Committee in his testimony this
week. “The economic outlook remains unusually uncertain.” The problem is that as long as the Fed
(and the Treasury) go on pretending that we can borrow our way to riches, there is nothing whatsoever
uncertain about the economic outlook. What his predecessor called “irrational exuberance” in regard to
a mere stock market bubble in the mid 1990s has become the only thing Mr Bernanke has left to count on
in the second half of 2010. Stock markets are places where misplaced confidence tends to shatter at
reasonably regular intervals. With global financial systems, the intervals are much more widely spaced.

All alone amongst his international colleagues, the head of the central bank of the US continues to
advocate borrowing and spending his way out of this dead end. He will likely continue to do so as long as
the US has the ability - as the world’s lender of last resort - to accumulate debt denominated in the same
currency it creates. The more that fiscal “austerity” grips the rest of the world, and the more that
governments translate what is so far largely talk into concrete action, the more the Fed is going to have to
“stand ready”. We do not know if, in extremis, Mr Bernanke (or Mr Geithner or Mr Obama) will go to
the extreme of destroying the US Dollar in order to “save” the US economy - and their ability to “run” it.
We do know that if they stay on their present trajectory, that is what they will accomplish.

As Mr Trichet said - “...the need to implement a credible medium-term fiscal consolidation strategy is
valid for ALL countries - NOW!” Mr Bernanke is the only central banker left who is bucking the trend.
The longer he does it, the more CERTAIN the “economic outlook” becomes - for the US in particular.

Recent Events:

US stock markets have been continuing their recovery from the lows set at the beginning of July. The
European “stress tests” have been taken and “passed” while US financial officials have reassured Wall
Street that the punch bowl remains firmly in place, at least in the “short-term”. Market signals are
becoming ever more perverse as US stock and bond markets rise together with yields on shorter-term
Treasuries registering all time lows.

Meanwhile, the US Dollar continues the falls it has been making ever since Treasury yields topped out in
April. The 6.6 percent fall (and counting?) on the USDX since April “should” have led to higher
Treasury yields by now. If the US Dollar was a “normal” currency, it would have. But the US is not a
“normal” currency, it is the reserve currency.

Gold:

For MUCH more on Gold - please see Gold This Week (GTW):
http://www.the-privateer.com/subs/goldcomm/gold.html

What’s Next?:

On July 25, a “United Nations command” made up of mainly US and South Korean warships kicks off
four days of naval exercises in the Sea of Japan in a show of “strength” designed to chastise the North
Koreans. As is usual in these instances, the North Koreans are muttering about “nuclear deterrence”.

On the markets, the traditional northern hemisphere “August doldrums” are now almost upon us. The
next FOMC meeting takes place on August 10. There will be no change in official US rates, of course.
But what the markets will be looking for - before and after August 10 - is any indication by the Fed that
they are going to decide to take one or more of the “further policy actions” mentioned by Mr Bernanke.
Late July Issue - Number 658 William (Bill) Buckler
Published: July 25, 2010 © 2010 - All Rights Reserved