Is he Harvey Two-Face or Janus? The 'he' we're referring to is US Federal Reserve Chairman Ben Bernanke. He thoroughly confused markets after the US close on Wednesday. On the one hand, the Fed will not necessarily end QE when the US unemployment rate reaches 6.5%. On the other hand, interest rates will not rise even if the Fed 'tapers off' bond purchases.

It was a remarkable exercise in speaking out of both sides of the mouth to the consternation and befuddlement of everyone. Only a god or a criminal would even attempt it. Harvey Dent - the one-time district attorney of Gotham - could have done it after he became Harvey Two-Face (tragic acid accident). And Janus, the two-faced Roman god of gates and doors, would have had a go.

In fact Janus is probably the better comparison for Bernanke. There are two doors in front of the Fed Chairman. Behind one door is a world of higher prices, a falling dollar, and inflationary pain. Behind door number two is a world of falling asset prices, a crashing bond market, and the inevitable deflation that comes after a credit boom.

Ben Two-Face has a hand on each handle. But he's not trying to open the doors. He's trying to keep them both closed. He will need more hands. In the meantime, the markets have taken the Fed's indecision as an excuse to rally.

Unfortunately for the Australian economy, there is the complicating factor of China. The IMF lowered its 2014 GDP growth figure in China by 0.3% to 7.8%. That's still pretty fantastic by most standards. But it might not be enough to prevent Australia from encountering its own little deflationary shock, which we'll address in a moment.

But back to China quickly. CSLA also downgraded its China growth forecast to 7%. This is a safe prediction. It probably won't be accurate though. There will be no GDP-boosting stimulus from the central government, according to Chinese Premier Lei Keqiang. He told other government officials that, 'As long as the economic growth rate, employment and other indicators don't slip below our lower limit and inflation doesn't exceed our upper limit, [we'll] focus on restructuring and pushing reforms.'

That's a reaffirmation of the idea that China's economy doesn't need growth at any cost. It needs to rebalance between exports and domestic consumption. It's probably the right policy. But there wasn't any evidence it's working yet, judging by data released yesterday. This is the data that took the wind out of Australian equity sales mid-afternoon.

Chinese exports were down 3.1% in June from the same time last year. Imports were down 0.7% year-over-year. This was not good news coming from Australia's largest trading partner. And it wasn't good news for China either. 'China faces relatively stern challenges in trade currently,' said Chinese customs spokesman Zheng Yuesheng. 'Exports in the third quarter look grim,' he added.

That's awfully morose talk for a country that showed a $29 billion trade surplus. And for Australia, the silver lining was that Australian exports to China rose by 11.9% in June compared to last year. The volume of iron ore exports was up 5.1% in the first six months of the year. But now we run into Australia's problem.

The increase in iron ore export volumes is making up for the decrease in iron ore prices. If China slows down even more, though, Australia's economy won't be able to make up the dent to national income with an increase in the volume of exports. The consequences will began showing up like falling dominos.

Professor Bob Gregory, a former Reserve Bank governor, spoke on just this scenario in an interview with the ABC. Professor Gregory warns of a 'deflationary shock'. The reasoning is easy to understand. The peak in mining investment is behind us, with a genuine 'tapering off' in front. At the same time, export prices are on their own not-so-gentle glide path lower.

Like our own Vern Gowdie, Professor Gregory reckons lower export prices and the end of the mining boom will lead to higher unemployment and lower wages, for which there is no quick fiscal or monetary fix. If you wanted to extrapolate that out to a single word you might end up with: recession. It will be the recession Australia cannot avoid having.

Or can it? This is where politics comes in. If you're reading from the Keynesian hymn-book, you counter-act falling private investment with more government spending. That means larger deficits. In the current political environment, you're unlikely to see either party arguing for more spending (maybe the Greens might).

So if you can't borrow and spend your way out of an economic soft patch, what do you do? Well, you might try pulling the interest rate lever. But it might not do anything anyway. Professor Gregory reckons that from this level, marginal declines in interest rates won't be enough to have any meaningful effect on consumer behaviour. In other words, cutting a few basis points from the cash rate is not going to open up anyone's wallet enough to keep the economy out of recession.

Your editor chatted about these subjects yesterday on the phone with Vern. His project - which we've tentatively named Gowdie Family Wealth - is how to preserve family wealth in a deflationary environment, when wages, stocks prices, houses and growth all shrink. Vern reckons that China's bubble has truly popped and that only now is Australia starting to feel the consequences.

We'll keep you posted on Vern's project. And in the meantime, in the value and sound money sector, our own Greg Canavan is right on the story. Greg is alert to the outlier possibility...that the China story unravels faster than the investment community is prepared for. He's calling it the Panic of 2013.

Will there be a panic? Well, based on the chart of the XLE energy sector fund we showed yesterday, there are some similarities between now and 2008. After a year of leaks, the levee finally broke and put investors underwater that year. If it happens again like this, there will be a different immediate cause (the bond market). But will it happen?

There are two things we've learned in the last few years. First, financial markets have become less stable, not more stable, since the crash began in 2007. Regular interventions make it possible to maintain the status quo for a little while. But they also distort incentives and turn more savers into speculators.

The second thing we've learned is that this can go on for much longer than you imagine. As our friend Rick Rule says, just because something is inevitable doesn't make it imminent. In geologic terms, you live on a fault line that you know will someday result in a big earth quake. But short of packing up and moving out (liquidating your entire stock market portfolio) you live with the risk and hope it doesn't happen while you're alive.

And if you're willing to live dangerously (who has a choice these days, really?) we still reckon you could do worse than look at energy investments. Yesterday we mentioned the coming energy crisis that will triple your electric bill. The politicians know it's coming so they're trying to get out in front of it.

Resources Minister Gary Gray made a remarkably sensible suggestion earlier this week. He said Australia should exploit its energy advantage by producing more natural gas. In a functioning free market, prices send signals. High prices (for natural gas) are a signal to producers to make more. More energy is the answer.

Is it that simple? Yes. It is. But not everyone sees it that way. Tomorrow we take on some critics who dispute that idea that credit is a kind of energy. Stay tuned...

Regards,

Dan Denning+
for The Daily Reckoning Australia