From Dan Denning in St. Kilda:

--Last time the world's financial markets panicked, something strange happened: the U.S. dollar and U.S. bonds rallied while stocks, commodities, and emerging markets sold off. The same thing could be happening now. It's not so much a flight to quality as it is a flight to liquidity and a massive case of global risk aversion.

--The S&P 500 fell by over three percent and the Dow Jones by 268 points and two percent (nearly closing below 10,000). Gold was off $45, or just over four percent. And oil was off by nearly $4, or over five percent. We'll get to what you should do about all that in a moment.

--But first, take a look at that chart below if you believe the past is prologue. The chart shows how impressive and fast the rally was in the U.S. dollar from a level of 72 on the dollar index to a high just below 90 in late 2008 and early 2009.

-- During the dollar's rally, stocks and commodities fell. Yet once low interest rates and government stimuli found their way into stock markets, leveraged traders again bet on equities and higher-yielding risk assets around the global. The dollar fell and the stock market rally got pretty carried away with itself (mostly on the flimsy idea that the global economy had been rebalanced and was recovering, which was palpably not true).

--The chart can't tell us what will happen next. This time around, we wouldn't expect the dollar rally to go as high or last as long. We don't think the monetary authorities would be inclined to let a deleveraging positive feedback loop set in again (which indirectly explained the dollar's ferocious rally last time). That is, the powers that be don't want to see falling asset values trigger forced liquidations by leveraged players, leading to more asset sales and further liquidations in property, commodities, and equities.

--Now just because Ben Bernanke and the global cabal of counterfeiters don't want something to happen doesn't mean it won't happen anyway. The deflating of the reflated asset bubble is going to happen sooner or later. The world's massive inverse pyramid of debt is supported by a very small asset base. When the underlying assets (often commercial and residential real estate fall) the whole structure becomes unstable (this is what happened in 2008).

--That means that this time around, you wouldn't expect the monetary authorities to let liquidity to dry up again. Granted, the fundamental issue is the soundness of bank collateral (and that has not improved much). But if central bankers and policy makers have been publicly worried about inflation in the last few months, you can forget about that now.

--A ten percent fall in stock prices (though probably overdue) is just the thing to get policy makers in an accommodative mood again. The U.S. employment figures still suck. And markets are increasingly confused and worried about whether certain sovereign nation states (like Greece and Portugal) can finance their deficits and/or reduce public spending without increasing civil unrest.

--Mind you, we don't think more money, credit, or liquidity is the answer. It is, in fact, the problem. The modern world economy is built on a foundation of unsound money. We may all be surprised at how just abnormal everyday economic life gets when the artificial life support of easy money is either withdrawn or simply ceases to be effective.

--The young man above, who's keeping vigil outside the RBA in Sydney, would probably agree with us. His brother sent us the picture and this note, "My younger brother has been protesting outside the RBA every second Friday morning for the last three months. After discovering Austrian economics about three years ago Seb and I have been compelled to speak out against central planning through central banking. I have attached a couple of photos above of his mornings outside the RBA. As you can see it's a lonely battle and would appreciate all the help we can get."

--Keep hope alive brother!

--If you're not familiar with Austrian economics, don't worry. There's actually a small introduction to the subject we wrote last year that we're happy to send you if you're interested. Just send us a note to dr@dailyreckoning.com.au with "Austrian Economics" in the subject line.

--The basic idea, when you strip away all the big words, is that the entire free market system is distorted/perverted/corrupted by the fact there's no free market for money. The interest rate is essentially the price of money (or the cost of capital). This rate is set by unelected bankers. The result, since central banking got its start with John Law and the Banque Royale in France, is a series of massive misallocations of capital and destroyed wealth.

--When you change the cost of capital willy nilly, you change all sorts of incentives in the real economy. And you alter the economics of tens of thousands of investment decisions. Make money too cheap (always the preference of governments) and you create asset bubbles (in stocks, real estate, and commodities).

--In fact there's a pretty persuasive argument that the commodity super cycle is itself a symptom of the de-facto dollar devaluation engineered by Richard Nixon in 1971. Once the world moved to free floating exchange rates and fiat currencies not backed by any metal, a tsunami of paper, credit, and debt has lifted (inflated) prices for everything (houses, stocks, commodities, and bonds).

--Some people call this wealth.

--But if the super cycle of paper money is ending (a big claim for sure), wouldn't it mean a dramatic contraction in global economic activity? Not just a severe recession like in 2008 but really, a long depression in which debts are worked off and paid down, or in which debtors simply default and their creditors must take capital-destroying losses?

--Well, yes. All that would happen if the super cycle in paper money is ending.

--We've argued that it IS ending and that one symptom is a series of escalating sovereign debt crises. The funding model for the welfare state is broken because it's base on unsound money. It's time to pay the reaper. Don't fear the piper.

--The argument we hear most often against our position is that all of that would be terribly inconvenient and people would prefer to not believe it. People would prefer to believe that debt is wealth, that you can spend your way out of recession, that we all can live at each other's expense, and that the misallocation of real resources (capital, labour, land and commodities) doesn't have real long-term consequences.

--But paper money has always been a con game based on belief. The emperors of Rome, the Kings of France and England, the chairmen of the Federal reserve cannot resist debasing the currency. It makes both warfare and welfare possible. Guns and butter are the health of the state and the death of sound money.

--The counterfeiters always get first use of the bogus money before its purchasing power is diminished by the increased supply. And after all, the modern banking system IS debt-based money. The banker's product is debt...and the more you have, the better for them.

--All of this is absurd and, as Murray Rothbard said about fractional reserve banking, deeply immoral. It's a pretty dodgy way to run a world economy. But the assumption - encouraged by the powers that be - is that the economy is a complex machine which can be controlled with the right tweaks to the right dials by the right people wearing the right suits in the right government offices with the right university degrees.

--This is also absurd.

--But enough of the theory. What now? If the correction becomes a rout, expect more quantitative easing or policy measures designed to mask the pain (more stimuli). That won't solve the basic problems either. But it might arrest the dollar rally and the commodities sell off. At some point, much more aggressive measures might be needed, at which point we'd expect to see a huge increase in inflation and interest rates (as deficits spiral out of control).

--But in the short term, we'd say this is a chance to lower your average purchase price on gold and other precious metals. We hope you used the rally as a chance to liquidate some of your stocks and increase your allocation to cash. Our preference right now is for liquidity over capital gains or yield. Cash doesn't yield much. But you can keep it in your hot little hands.

--Of course no one can see too far into the future. We're pretty sure that at some point down the road, the sovereign debt crisis will again become a U.S. dollar crisis. But it could be that the sovereign debt crisis is going to take out the smaller welfare states in Europe first and that this will actually lead to dollar strength as global investors concentrate their remaining capital in a few very liquid markets (like short-term U.S. Treasuries). Under this scenario, emerging markets (including Australia) would probably sell off more than developed markets.

--One final note today. The South Australian Attorney-General, Michael Atkinson, has changed his tune on the new law requiring internet commenters to reveal their identity when commenting on the upcoming election. That seems like good news.

--Atkinson wrote in a statement, "From the feedback we've received through AdelaideNow, the blogging generation believes that the law supported by all MPs and all political parties is unduly restrictive. I have listened. I will immediately after the election move to repeal the law retrospectively."

--Hmm. "It may be humiliating for me, but that's politics in a democracy and I'll take my lumps...This way, no one need fear now that they are being censored on the net or in blogs, whether they blog under their own name or anonymously. I call upon all the other political parties who supported this review to also review their position."

--Maybe Mr. Atkinson should review his analysis as well. From his comments, he seems to be unrepentant about the spirit of the law. But he says that because all the young whipper snapper bloggers don't like it, well that's democracy so we'll respect that, even if all the youngsters are a bunch of dunderheads.

--The danger here is still clear. You have an elected official exercising his own discretion about what speech ought to be free, and then exercising even more discretion about whether to apply the law or not. How capricious. The law is the law. How can the Attorney-General not exercise it?

--But really this shows why you need a constitutional protection for free speech in Australia. Take it out of the hands of legislators and put it above statutory law entirely. In some sense, this IS un-democratic in that you're telling the legislature there are some individual rights they can't tamper with just because it seems like a good idea at the time. In that case, we're happily un-democratic.

--Protecting individual liberties is the fundamental reason (we think) for consenting to be governed in the first place. If the legislature becomes a tool for systematically stripping you of your economic and political liberties (as well as grabbing, without your consent, a larger and larger percentage of your productivity via the income tax), you'd have a serious think about withdrawing your consent.

--Hmmn.