As the crisis deepens, Washington draws ever closer to the “nuclear” option. How will we know when they take it? The dollar will be destroyed...

“What we got here is... failure to communicate. Some men you just can't reach. So you get what we had here last week. Which is the way he wants it. Well, he gets it. I don't like it any more than you men.”

- Captain, Road Prison 36, Cool Hand Luke (1967)

Now, this is what you might call a “fluid situation.”

The Dow is down 400 points as I sit to write you on a Monday afternoon. Where it will be an hour from now, let alone a day from now, is hard to say.

I was hoping to dig into the mailbag today, but the pace of events is too fast and furious to step back and reflect just yet. I’m still reading, though, and still hoping to get to your comments and questions soon.

Here’s a quick take on what I think is happening:

• Wall Street is deeply worried that Congress -- and by extension, Main Street -- “doesn’t get it.”

• Underneath the surface, the situation is far more dire than the general public yet understands.

• The panic has spread to Europe, and is beginning to engulf hedge funds.

• The bailout plan as approved by Congress (if it doesn’t get shot down again by the time you read this) is the tiny tip of a far larger iceberg.

• The powers that be have not yet gone “nuclear” in response to the crisis. They have not pulled out all the stops... which is why Wall Street is still in white-knuckle mode.

• The powers that be will indeed go “nuclear.” It’s just a matter of time.

Failure to Communicate

Let’s talk about Cool Hand Luke for a second.

Paul Newman, rest in peace. Cool Hand Luke was one of the actor’s greatest roles in a lifetime of great roles. In the movie, Newman plays a Florida prisoner who lives in defiance of the system. Luke refuses to give up his dream of freedom -- no matter the ultimate cost.

Time and again Luke bucks the system, and time and again the system breaks him. Luke dies in the end -- shot through the neck in a police standoff -- but the memory of his irrepressible spirit lives on.

So what does this have to do with the what’s happening?

The way I see it, Cool Hand Luke represents those irrepressible spirits fighting against the bailout tide. The reluctant captain of Road Prison 36 (he of the “failure to communicate” quote) represents the reality of what we’re dealing with here.

Make no mistake; in my heart I side with Luke. I would love to “throw the bums out” or “let ‘em hang.” I would love to see the Federal Reserve abolished. I would love to see Wall Street made to pay for its sins. I would love to see the wrongs righted and the guilty punished and a better system put in place.

But the time for all that is not now. You tinker with the system when things are going well -- not when they’re going to hell in a hand basket.

We can no more fire the stewards of the global financial system in the midst of a crisis -- even if they are ham-fisted dolts -- than we can shut down America’s air traffic control system without knowing what will replace it.

Too Much Leverage

The problem, in a word, is leverage. Rightly or wrongly, we all got leveraged up to the eyeballs these past few years. Not just the Wall Street banks (though they were the worst offenders), but everyone, including U.S. consumers.

As we all know by now, the offending financial institutions -- be they bought out or bankrupted or absorbed -- were leveraged by as much as 30 or 40 to 1. That’s the equivalent of making a $100 bet with two or three bucks in your pocket, declaring yourself “good for it” if the bet goes bad.

So now, thanks to the laxity of Greenspan, Bernanke, the SEC, Congress and others, we’re saddled with “capitalism on the upside and socialism on the downside,” as some have aptly put it. Wall Street’s stupidly big bets have become everybody’s problem.

But you know what? Joe Sixpack got himself nicely leveraged, too.

Spengler of the Asia Times observes, “Leverage is the secret of American wealth. The average American family in 2004 had a net worth of US$448,000 on an income of $43,000, according to the Federal Reserve's survey.”

When Americans talk about their net worth, they are largely talking about two things: the value of their homes and the value of their investment portfolios. Both those numbers are greatly inflated by the built-in leverage of the system.

For example, what is a house worth? Whatever someone is willing to pay for it... the “multiple” of which depends greatly on a few key things. (Like functional credit markets, for one.)

And what is a stock worth? Whatever multiple someone is willing to pay for the company earnings stream... again based on a handful of key factors.

The upshot is that the average American is leveraged, too, by a factor of 10 to 1 or more. And we’re only talking about Americans with positive net worth here -- not to mention the trillions in pension funds.

If the financial house of cards comes crashing down, it doesn’t just crush Wall Street. It crushes Main Street, too. This is what the Cool Hand Lukes who want to say “screw the system” don’t understand: We as a country are too deep in the system to survive its sudden demise. When you’re in up to your neck, you can’t walk away.

The Mellon Plan: Not an Option

Andrew Mellon was the only Treasury secretary to have served under three U.S. presidents. He held office from 1921 to 1932.

After the crash of ’29, as the Great Depression got underway, Mellon made his position known as a “liquidationist.” Mellon’s famous advice in response to the budding ‘30s crisis: “Liquidate labor, liquidate stocks, liquidate farmers.” In short, liquidate everything in sight. Let the weak fail... and let God sort them out.

That’s simply not an option today. Our entire system is built on leverage. That is the Achilles’ heel of modern financial markets.

In normal times, it’s a good thing that a young couple with a promising future can buy a house on 20% down. In normal times, it’s a good thing that a single mother can get a low monthly payment on a car so she can drive to her new job. In normal times, it’s a good thing that an entrepreneur can get a loan to start up a small business.

But all those good things require debt and leverage... on at least one side of the equation, if not both.

Leverage, like debt, is not an inherently bad thing. It’s a tool that can be used or misused. The ability to use leverage efficiently has played a large part in our current prosperity. But as a result, the use of leverage has become too common and too widespread to just say, “liquidate.” We’re in too deep... we no longer have access to the “Mellon plan.”

The Nuclear Option

This is why I think the powers that be will go “nuclear” in a way we haven’t yet seen.

That is to say, when the depth of the danger really hits home... when it sinks in that the viability of the entire system is at stake, and that we are all at risk of being sucked into the deleveraging vortex... the public and political resistance to a full-blown, no-holds-barred rescue will evaporate.

We haven’t seen the full-blown response yet, only shades of it. But it is coming.

On Monday we got news that Wachovia (WB:NYSE), another major American banking institution, would disappear. The Fed took great pains to clarify it was “not a failure” like WaMu (WM:NYSE)... but another giant bites the dust nonetheless. We also got word that Fortis (FORB:EBR), a Belgian bank, is on the brink. (Welcome to the party, Europe.)

In response to all this, the Fed announced plans to pump $630 billion into the global financial system, according to Bloomberg. By the time you read this they may well have pumped a lot more. (Tell me again why $700 billion is supposed to a big number?)

Last but not least, the Dow was down 400 when I started writing. Now it’s down 500...

The plumbing of our global financial system is rotten. Pipes are bursting left and right. A bunch of fat-cat bankers may be the ultimate culprits, but we all played a part... and it’s the only system we’ve got.

This is why I believe the governments of the world -- China, Europe et al included in this -- are just going to keep throwing more resources at this “problem” which has become everyone’s problem. The responses will get bigger... and bigger... and BIGGER.

Really, what other option is there?

We cannot just “ride this out.” We cannot just “let it pass.” Full-on liquidation would be the equivalent of economic and political suicide. It is going to keep getting worse until the powers that be come up with the most dramatic response they can muster.

We haven’t gotten to that point yet. The “nuclear” option -- in terms of flooding the system with enough dollars to flood the Panama Canal, or even writing outright checks for U.S. equities a la Hong Kong in 1998 -- has not been tried.

It’s going to get worse from here. And so the government is going to do more. And they will keep doing more until things have been turned around, at least on paper.

“This Sucker Could Go Down”

“This sucker could go down,” as President Bush so eloquently put it last week.

The U.S. electorate and Congress did not really believe the Commander in Chief, seeing as how he has been so dead wrong on so many other things. They thought the crisis could be handled with a helping of provisos and quid pro quos -- a little urgency with a little temperance, too. They didn’t really believe that the entire global financial system as we know it was at stake.

But, like it or not, it is at stake. As much as I find it surprising to agree with Dubya, this “sucker” really could “go down.” I view this not as a moral assessment, but a structural assessment... like an engineer testing the joints on a suspension bridge and finding it in danger of collapse. It doesn’t matter whether the situation is fair or unfair, or who screwed up the bridge or built it poorly in the first place. It just is what it is.

When the truth sinks in, the powers that be will do all they can to prevent collapse from happening. The blame game will by sidelined by emergency the task at hand.

And how do I know Washington et al haven’t “done all they can” yet? Because the dollar, heading into its twilight days as the world’s reserve currency, has not yet been destroyed.

That’s the final outcome of the von Mises prophecy... the final reality of the Austrian Endgame. And it’s where we are headed. When the dust clears, it may be recognized that we had to pass through this panic point, to reach the height of realization of what’s at stake, before the true “nuclear” measures were implemented.

Gold Shines Here and Now

There are few areas where I’d be willing to buy with both hands right now. There are some incredible bargains out there to be sure. But as the market bleeds, they are just becoming even more incredible.

I still think the “stocks in the stratosphere” scenario as laid out last week is likely to play out, as the flipside of a U.S. dollar meltdown plus hyperinflationary stimulus.

I think that, with the Dow in full-blown crash territory, we are closer to that “nuclear” trigger point now than we were before. It’s a bit of a counterintuitive thing... before we get paper asset lift-off, things have to get bad enough to panic the powers that be into creating the inflationary conditions that fuel lift-off.

In other words, you don’t walk the path of Zimbabwe and Weimar Germany if you can avoid it. A big part of my thesis is that America’s path is predestined -- and we’re being forced onto that path now.

Being a trader at heart, I prefer to buy when the prices of things I like are going up, even when I’m buying for long-term investment purposes.

Today, what’s going up is gold.

Gold stocks aren’t following suit in the short term, but that’s because frightened hedge funds continue to dump assets left and right. We are witnessing a fire sale of epic proportions. I believe that hard on the heels of this we will see a stimulus injection of epic proportions, and that will push a lot of hard assets higher.

So you could do far worse now than to get your hands on gold: physical gold, gold ETFs, gold stocks. That’s the general ranking in order of safety vs. risk. I like them all now. Gold and gold stocks also make a compelling case for a trade from the technical side.

On the fundamental side, as the reality sinks in of what’s ahead of us, I believe gold will punch through its old highs and keep going (and going... and going... and going...).

Keep a cool head, and I’ll do my best to keep you informed.

Warm Regards,

JL

P.S. With the House voting down the $700B bailout, the markets crashed heading into Monday's final hour. So Congress indeed doesn't get it. Well, they will...

P.P.S. From Yahoo Finance late Monday: “Republican Congress members said during a press conference that they are going back to the drawing table on the financial plan as both political parties blame each other.” Yeah, the biggest intraday S&P decline since 1987 is kind of a bad sign, huh, fellas? They'll pull out the big guns soon enough.


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