On the other hand, gold’s big drop was clearly a victory for deflation, not inflation. And we got an item from the Wall Street Journal that reminded us that the U.S. economy is still just beginning a deflationary pullback:

“Record Store Closings.”

We were too busy to read the accompanying article. For a second, we thought we might have misread the headline. Maybe it meant that ‘record stores’ were closing. Then we remembered; there aren’t any stores that sell records any more. So, we must have read it right the first time – retail is in trouble.

There is probably nothing surer, dear reader. After a spending spree that saw Americans spend ALL there money...and then some, they are not now going to spend MORE. It’s not possible. Instead, they are going to spend less. And that means the retailers are going to sell less. And it means that they are going to need fewer clerks...and less space.

This is not the time to be holding retailers...or shopping malls – especially those that are far out in the boonies.

Bill Bonner
The Daily Reckoning Australia

• What’s a Consumer Economy Need in Order to Keep Growing?
• The Fog of the ’Flationary War is Lifting
• Government Could Succeed in Reflating the Bubble
• Giant Costco Opens in Melbourne!
• Gold is an Antidote to Paper

Naturally, the papers are squawking about inflation today. The Financial Times worries that inflation is going to undermine pensions and retirement plans. The International Herald Tribune , meanwhile, says inflation is undermining central banks’ efforts to...well...cause inflation!

Wait – we know what you’re thinking. Something is very wrong with a world where central banks cannot cause inflation any time they want to. Next, they’ll be telling us that you can’t have a cigarette when you want one...

But the papers are full of remarkable things...so why not? Besides, there are so many petards in central banking anyway; Bernanke and company were bound to get hoisted on one of them.

A society has no more real savings (resources set aside) than it actually has. And it sets interest rates (the price of those savings) as it sets any other price – on the basis of supply and demand. When the Fed intervenes with artificially low rates, it is merely pretending that it has resources available that it does not actually have. That is the trick known popularly as “inflation,” in which the supply of purchasing power is inflated with money that doesn’t exist.

Since the beginning of the credit crisis last summer, Fed policy has been purely inflationary – intended to convince people that they had more money and credit than they thought...and that they should spend it and invest it. But that policy can’t work forever. Eventually, consumer prices rise sharply. Then, the game is over...the Fed has to “lower inflation expectations” before it can inflate again. The hocus pocus only has a positive effect, in other words, as long as people are misled...once they catch, the jig is up.

And here we beg readers’ attention of a moment of deeper thought. This classical, cynical view of inflation seemed to be wrong for so long people began to think it was wrong forever. An entire generation has grown up with 1) a dollar with no connection to gold, 2) a dollar that actually rose against gold for 20 years, 3) Wal-Mart’s Every Day Low Prices, 4) apparently inexhaustible supply of cheap labor 5) globalized markets and supply chains and 6) falling bond yields. No wonder people began to think that inflation was no problem...and never again would be. Central bankers claimed they could now control economic cycles so as to have growth without inflation...boom without bust...forever. But forever seems to have come to an end already.

“The specter of inflation has risen over financial markets...” begins the IHT story.

Central banks can only get away with making money easier to get when consumer prices are under control. When prices for gasoline, milk and margarine begin to rise, people get fussy. They want their central banks to stabilize prices. And central bankers themselves look at their lending rates and get a little embarrassed. “How come you’re lending money so cheap?” economists ask them.

The fear is that if inflation is allowed to get “out of control,” it takes harsh policies to bring it back in line. Harsh policies are what everyone wants to avoid...especially before an election.

Classical economics tells us that an asset price bubble is always followed by an asset price bust. Inflation is followed by deflation, in other words.

But in our funny, complicated world, we get both inflation and deflation at the same time. The last two big bubbles – in residential housing and the financial industry – are deflating. Prices are going down for both assets. But inflation-sensitive commodities, most notably oil and gold, have soared. And now prices seem be working their up all along the chain...from the oil wells, to the shipping containers, to the Chinese sweatshops, to the shelves of Wal-Mart. A photo in today’s paper, for example, shows a pump at a filling station in New York with diesel fuel over $5.

What this means to central bankers is that they have to watch it. They can’t cut rates so freely...not while consumer prices are rising. Instead, the pressure will be on the other side – to raise rates.

To the man on the street it means that he has to prepare to pay higher prices for everything.

And to investors? What does it mean? It means inflation will do the work the bear market hasn’t been willing to do – that it will reduce the real value of stocks and bonds, even if nominal prices remain steady. Tim Bond, of Barclay’s Capital says, “investors have to be prepared for a few very unpleasant years. Bonds of all types – aside from index-linked – have no place in portfolios at current yields. Equity exposure should be narrowed to resources, energy, industrial goods and services – and once the write offs are completed – financials.”

Bill Bonner
The Daily Reckoning Australia

• Beliefs That Central Bankers Will Save the Day
• A New Hotline Service – Made Just for Central Bankers
• Central Banker Hotline Still Waiting for its First Call
• Central Banks’ New Money is Piling Up
• Investors Fear Rising Inflation

So far, things have worked out more or less as we expected. The “war” between inflation and deflation has produced plenty of noise and casualties...but no decisive victory.

We guessed that the Fed would be far more interested in fighting a deflationary recession than in fighting an inflationary boom. America’s central bankers see their mission in three parts – to protect the value of the dollar...to protect the banks...and finally to make sure that all politicians are re-elected and all Fed governors are reappointed. This last part of their mission leads them to ignore the first part. In order to help the career prospects of politicians and their Fed appointees, the latter must try to keep the economy moving forward – even to its own destruction. In the present context, that means holding off badly needed corrections. Consumers, government and business are all deep in debt. But none of them are going to cut back on spending unless they have to. A correction would force the issue; so, it is to be avoided at all costs. And the most direct and immediate cost is what is supposed to be the Fed’s number one priority...the U.S. dollar.

We guessed that inflation would push up commodity, oil, gold and consumer prices...more than it would help the real economy and stock prices. That seems to have happened too. Commodities, oil and gold have all soared. The economy, meanwhile, is growing more slowly than the population. And stocks rallied and retreated – and ended up about where they were 10 years ago.

But what about the kind of inflation people worry about? What about consumer price inflation? How come consumer prices have not gone up more?

Give it time...dear reader...give it time.

This week, both the Bank of England (BOE) and the European Central Bank (ECB) decided that it was more important to fight inflation than it was to try to boost economic activity. Both left their key lending rates where they have been – at 5% for England, 4% for Europe – or two to two-and-a-half times the Fed’s rate. Naturally, each of the 7 rate cuts in the United States made the U.S. dollar less attractive; who wants to hold a deposit in dollars paying 2% when he can shift his money to euros and earn twice as much?

Speculators saw the trend coming and sold the dollar down below $1.60 per euro – and sent gold over $1,000. Then, they saw what looked like the end of the line for this trend too. The Fed only has 200 basis points left. And it has warned that there may not be any more cuts coming soon. The dollar strengthened. Currently, it is at $1.53 per euro. Gold also retreated...and yesterday stood at $882

Meanwhile, Claude Trichet, head of the ECB warns that we may be in for a “rather protracted period of high inflation.” The BOE also says it has to try to keep a lid on inflation. The Daily Mail came out with one of its shocker stories two days ago, saying inflation had so raised the cost of necessities in Britain that the average household now has less discretionary spending money than it had 17 years ago. In effect, the typical family is poorer than it was in 1991.

We have not seen comparable numbers for the United States, but we suspect they will show the same thing: that by the time a family has finished paying for food, fuel and medical care it has less money left over than it had before Bill Clinton’s first term. Why? Because inflation is doing its work – it is reducing Americans’ real wealth.

But so far, it has come in like a black cat at midnight...on paws so silent hardly anyone has noticed. The U.S. government even claims it is not there at all. “Core” inflation is still under control, say the feds.

What was amazing about the last 20 years was that the dollar-based monetary system worked as well as it did. You would have thought – and we did think – that once the link with gold was severed in 1971, there would be no stopping inflation. Instead, inflation went down...to levels that hadn’t been seen since Eisenhower. Why? Because there were so many things holding consumer prices down – 2 billion new workers in the labor pool, Wal-Mart’s Everyday Low Prices, just-in-time inventory systems, computers, globalization, deregulation, and the rise of modern capitalism worldwide. But now, the benefits from those trends seem to have reached their limits.

Labor rates are going up rapidly in China and India. Commodities are soaring...governments are re-regulating...modern capitalism has been weakened by its own excesses...and inventories are at 40-year lows.

Inflation – like everything else in the financial markets – has been globalized. And soon, inflation will come in – not as a little kitty, but as a mean panther...

Bill Bonner
The Daily Reckoning Australia

• The “War” Between Inflation and Deflation Has Produced Plenty of Noise and Casualties
• A Merciless War Between Inflation and Deflation
• War Between Inflation and Deflation Leaves Millions of Casualties
• Lending Rates Will Go Up With Inflation
• A New Hotline Service – Made Just for Central Bankers

So far, things have worked out more or less as we expected. The “war” between inflation and deflation has produced plenty of noise and casualties...but no decisive victory.

We guessed that the Fed would be far more interested in fighting a deflationary recession than in fighting an inflationary boom. America’s central bankers see their mission in three parts – to protect the value of the dollar...to protect the banks...and finally to make sure that all politicians are re-elected and all Fed governors are reappointed. This last part of their mission leads them to ignore the first part. In order to help the career prospects of politicians and their Fed appointees, the latter must try to keep the economy moving forward – even to its own destruction. In the present context, that means holding off badly needed corrections. Consumers, government and business are all deep in debt. But none of them are going to cut back on spending unless they have to. A correction would force the issue; so, it is to be avoided at all costs. And the most direct and immediate cost is what is supposed to be the Fed’s number one priority...the U.S. dollar.

We guessed that inflation would push up commodity, oil, gold and consumer prices...more than it would help the real economy and stock prices. That seems to have happened too. Commodities, oil and gold have all soared. The economy, meanwhile, is growing more slowly than the population. And stocks rallied and retreated – and ended up about where they were 10 years ago.

But what about the kind of inflation people worry about? What about consumer price inflation? How come consumer prices have not gone up more?

Give it time...dear reader...give it time.

This week, both the Bank of England (BOE) and the European Central Bank (ECB) decided that it was more important to fight inflation than it was to try to boost economic activity. Both left their key lending rates where they have been – at 5% for England, 4% for Europe – or two to two-and-a-half times the Fed’s rate. Naturally, each of the 7 rate cuts in the United States made the U.S. dollar less attractive; who wants to hold a deposit in dollars paying 2% when he can shift his money to euros and earn twice as much?

Speculators saw the trend coming and sold the dollar down below $1.60 per euro – and sent gold over $1,000. Then, they saw what looked like the end of the line for this trend too. The Fed only has 200 basis points left. And it has warned that there may not be any more cuts coming soon. The dollar strengthened. Currently, it is at $1.53 per euro. Gold also retreated...and yesterday stood at $882

Meanwhile, Claude Trichet, head of the ECB warns that we may be in for a “rather protracted period of high inflation.” The BOE also says it has to try to keep a lid on inflation. The Daily Mail came out with one of its shocker stories two days ago, saying inflation had so raised the cost of necessities in Britain that the average household now has less discretionary spending money than it had 17 years ago. In effect, the typical family is poorer than it was in 1991.

We have not seen comparable numbers for the United States, but we suspect they will show the same thing: that by the time a family has finished paying for food, fuel and medical care it has less money left over than it had before Bill Clinton’s first term. Why? Because inflation is doing its work – it is reducing Americans’ real wealth.

But so far, it has come in like a black cat at midnight...on paws so silent hardly anyone has noticed. The U.S. government even claims it is not there at all. “Core” inflation is still under control, say the feds.

What was amazing about the last 20 years was that the dollar-based monetary system worked as well as it did. You would have thought – and we did think – that once the link with gold was severed in 1971, there would be no stopping inflation. Instead, inflation went down...to levels that hadn’t been seen since Eisenhower. Why? Because there were so many things holding consumer prices down – 2 billion new workers in the labor pool, Wal-Mart’s Everyday Low Prices, just-in-time inventory systems, computers, globalization, deregulation, and the rise of modern capitalism worldwide. But now, the benefits from those trends seem to have reached their limits.

Labor rates are going up rapidly in China and India. Commodities are soaring...governments are re-regulating...modern capitalism has been weakened by its own excesses...and inventories are at 40-year lows.

Inflation – like everything else in the financial markets – has been globalized. And soon, inflation will come in – not as a little kitty, but as a mean panther...

Bill Bonner
The Daily Reckoning Australia

• The “War” Between Inflation and Deflation Has Produced Plenty of Noise and Casualties
• A Merciless War Between Inflation and Deflation
• War Between Inflation and Deflation Leaves Millions of Casualties
• Lending Rates Will Go Up With Inflation
• A New Hotline Service – Made Just for Central Bankers

But now, two things are happening:

First, the planet seems to be running low on easily obtainable energy. Cheap oil fired the furnaces, filled the pistons, and greased the gears of the whole machine. Now, oil is not so cheap... In fact, it hit a new record high last week.

Second, the non-Europeans have caught on to the magic of the Industrial Revolution. They're building newer and better factories - and staffing them with cheaper, harder working labor. What's more, they're competing with the West for the raw materials to feed their factories. And, perhaps most important, they've got money - mountains of it. While Europeans - led by Anglo-Saxons - squandered their wealth on pointless wars and frivolous spending, the non-Europeans have been saving and investing. The Chinese, for example, are said to save more than 25% of their incomes.

And now, a kind of financial war seems to have broken out. We have opined that this is not merely a war between inflation and deflation...but a war of Total Liquidation...in which the huge debts built up during the expansion phase of the credit cycle - roughly, 1980-2007 - mostly in the West, especially in America and Britain, will be written down, written off, and inflated away.

Neither inflation nor deflation will be a clear winner, in other words. Instead, like WWI, both will do damage...and in the end, very few people will be better off. Some possible exceptions - gold miners, commodity producers, and emerging markets.

No one will benefit much from deflation. But commodities and gold will reap some gain from inflation.

On Friday, for example, we saw both in action. The Dow tumbled 256 points - after GE proved that it could was vulnerable too. Its shares lost 13% of their value in a single day. What provoked the run on GE was disappointing earnings - particularly, you guessed it, in its finance division.

Finance was the big winner in the expansion of 2002-2007; it will be the big loser in the contraction phase.

While deflation was battering investors' wealth...inflation was aiming its wallops at consumers' budgets. Rice and oil hit record highs. Corn and tin too.

Interestingly, $6 corn is too much for the ethanol business. The industry was a fraud from the get-go, requiring taxpayers' money to justify turning corn into fuel. But now, even with subsidies, corn is too expensive and the ethanol producers are going bust.

They deserved it. But pity the poor people who have to eat. A handy chart on this weekend's edition of El Pais shows what has happened to basic food prices. In the last two years, corn, wheat and rice have all more than doubled. And get this, in 2007, stockpiles of these grains fell to their lowest level in 25 years.

No wonder there are food riots breaking out all over the place.

But let's return to our big picture view.

Inflation and deflation only appear to be "at war" with one another. Sometimes inflation has the upper hand. Sometimes, deflation. But over the next few years they will make common cause in the destruction of wealth in America, Britain and a few other economies.

Why do we single out the Anglo-Saxon economies? Because they were the ones that most feverishly embraced what became known as the "Anglo-Saxon model" of economic growth, what our friend Kurt Richebächer used to call "late, degenerate capitalism," marked by a freewheeling financial industry, widespread securitization of debt, and overall debt at breathtaking levels.

One awkward feature of this model was the fact that the rich got a lot richer...while the poor stayed about where they were.

The Financial Times explains:

"After decades of 'financialisation' in the US and other Anglophone economies, whereby financial services have increased their share of gross domestic product, banks are being bailed out - using public money...

"From a political perspective the notable feature of the inegalitarian, free-market era that began in the 1980s is how little backlash there has been against the stagnation of ordinary people's earnings in such a large portion of the developed world economy....This is potentially dangerous territory...

"Between 1979 and 2005 the pre-tax income for the poorest households grew by 1.3 per cent a year, middle incomes before tax grew by less than 1 per cent a year, while those of households in the top 1 per cent grew by 200 per cent pre-tax and, more strikingly, 228 per cent post-tax.

"The result of this lopsided distribution of income growth was that by 2005 the average after-tax income for the bottom fifth of households was $15,300, for the middle fifth $50,200 and for the top 1 per cent just over $1m.

"Looked at from another perspective, in 1979 the post-tax income of the top 1 per cent was 8 times higher than that of middle income families and 23 times higher than the lowest fifth. By 2005 those ratios grew respectively to 21 and 70. The process reached its extreme point with US President George W. Bush's tax cuts. Emmanuel Saez of the University of California at Berkeley estimates that in the economic expansion of 2002-06 the plutocratic top 1 per cent captured almost three-quarters of income growth.

"Figures for wealth, derived from the Federal Reserve Board's Survey of Consumer Finances, are less up-to-date but the picture is similar. The share of US wealth owned by the top 1 per cent of households rose steadily from 20 per cent in 1976 to 38 per cent in 1998."

The backlash has already begun - just listen to America's presidential candidates. They're all bidding for the resentful voter - complaining about high executive salaries, kvetching about the Bush Administration's bail out of the banks, and whining about tax cuts for the rich. They all want to soak the rich...and bailout the 'little guy.'

But they can stop worrying. Wealth is self-correcting. Economic success is self-healing. In this new downturn, the rich will lose more than the poor - simply because they have more to lose. They were the big gainers from the Industrial Revolution...and then the late, degenerate financialization stage of capitalism. They will probably be its biggest losers too.

Bill Bonner
The Daily Reckoning Australia

• Farmers Feel Consumers Blame Them for High Food Costs
• Saving Money, Not Spending it, is the Key to Getting Wealthier
• US Has Highest Unemployment Rate of All Major Economies
• Rich Blamed for Financial Debacle of Last Few Years
• Aquaculture: Soybeans and Corn Under Water

What we're thinking about is that we have entered a much more dangerous and troublesome period in world financial history. The planet was leveraged up. Now it is going to be de-leveraged.

We have been talking about the battle between the forces of inflation and the forces of deflation. It is not clear which way it will go...or when. The feds - who favour inflation - seem to have the upper hand one week. The next week, Mr. Market - who seems to have thrown his lot in with the force of deflation - seems ahead on points.

Meanwhile, many of the foot soldiers are lost, separated from their units...shooting at their own men...and often blowing themselves up. Many don't know which side they are on and are willing to switch sides at any minute. But in the fog of war you always get a lot of people bumping into one another. That's why we get such peculiar reports from the front - such as when the feds cut short rates (which is inflationary)...but long rates nevertheless go up (which is deflationary). Or when the unemployment numbers go up (which is deflationary)...causing the dollar to fall (because investors expect another inflationary rate cut!)

No, we don't know exactly which way it will go (so don't ask us when gold will hit $2,000...or when the Dow will break below 10,000). But it scarcely matters. Because, we're like the innocent civilians caught in the crossfire. Sooner or later, our assets are going to be shot down...and our liabilities are going to blow up. In other words, dear reader, this is not a war in which you should try to speculate on which side will win...this is a time to keep your head down.

It's a Liquidation War...in which mistakes will be corrected BOTH by inflation and deflation. Take stock prices, for example. Our guess is that they'll be taken down - either by inflation or deflation, or both. Prices will fall either in nominal terms, in other words, or relative terms. Already, adjust the Dow to the price of gold, or wheat, or oil, or copper and you get a very different picture. Instead of being flat over the last 10 years...the Dow is down a half to two-thirds.

"It's the Greater Depression," said Doug Casey at dinner Monday night, with a satisfied look on his face. "I've been expecting it for a long time. I was a little early. But now, it seems to be finally getting going."

What happens in a Greater Depression? We don't know, but we think we're going to find out.

And we imagine its most important feature will be a general markdown of debt and the relative value of Western assets - stocks, houses, currencies, and labor. The East and developing world is on the rise; even if it stays put, the West, in relative terms, will sink.

Some assets will go into default - which is what is happening in the financial industry lately. UBS alone has lost 38 billion. Hedge funds are going broke. And the captains - present and past - of the financial industry are pointing fingers at each other.

Many people say we've seen the bottom for equities, and the financial sector in particular. Maybe in nominal terms. And maybe in the East and the developing world. But in America, in real, inflation-adjusted terms, we'd expect more of a selloff. The S&P is still selling for more than 18 times earnings; there is still plenty of room on the downside.

The financial sector looks particularly bad; there's probably a lot more bad news coming. And since it was the big winner for the 25 years, it probably needs a bear market of at least 5 or 10 years. At the beginning of the boom in finance, which began roughly during the first Reagan Administration, people still wanted their children to grow up to be doctors, lawyers and businessmen. At the end of it, every mother's son was encouraged to into 'finance.'

But now, the bubble in finance is over. It will probably take many years before values appear and prices begin to rise - just look at what has happened in the NASDAQ. Or look at our favorite example - Japan. Many people thought Japanese stocks were a once-in-a-lifetime bargain after the Nikkei Dow crashed in 1990. Well, they're an even bigger bargain today!

Bill Bonner
The Daily Reckoning Australia

• Fall in Commodity Prices Will Reduce Inflationary Forces
• Inflation and Deflation Battle is a Long Way from Won
• The Ghost of ’70s Inflation and the Ghost of ’30s Deflation Will Scare the Living Daylights Out of Us
• A ‘Draw’ in the ’Flationary War
• A Merciless War Between Inflation and Deflation

But that's just the way globalization works. We have nothing against it, but neither would we mind if there were less of it. Which raises the big question: is the leveraged planet becoming even more leveraged... or less so?

Ah, dear reader... this is where inflation and deflation make common cause. They both de-leverage the world... reducing the value of debt - either by defaults or by lowering the real value of the debt itself. That is the real story in the financial markets... and in the housing market: leverage is being marked down. A residential mortgage worth $200,000 two years ago may be worth only $150,000 now, for example. Bear Stearns - worth billions a few months ago - is now worth peanuts.

Inflation takes leverage down too. All those U.S. dollars held abroad (and at home, for that matter)... all those dollar-denominated Treasury bonds... all those dollar denominated I.O.Us - they all lose value as inflation increases.

Just take those 2 trillion odd dollars outside America. Every one of them is a claim against U.S. assets - land, houses, tractors, food, stocks, buildings, you name it. And as inflation takes prices upwards, each of those dollars falls to the ground... it will buy less of what the United States has to offer.

We have been talking about the battle raging between inflation and deflation. But this is one way to win, no matter which side comes out ahead. Want a sure bet? Bet on de-leveraging. How do you do that? There are many ways. Sell the industry that provides leverage, for example - the financial sector. Sell Wall Street on rallies, in other words.

Yesterday was a good day to sell. After having gone up more in a single day than the entire value of the Dow in '29, it was time to take profits. And that's what investors did. The Dow sold off a little.

Gold, meanwhile, gave investors a buying opportunity. At $887, we're not saying that that is the best price this correction will offer... but it wasn't bad. And many buyers decided to take advantage of it. Gold rose back to $900 .

Now let's look at the U.S. economy itself. Ah... so many foreclosures... so little time.

Food up 9%. Houses down 11%. What's an upside-down homeowner to do but walk away? According to yesterday's USA Today , so many are walking away in Denver that it is producing an 'Exodus' of Biblical proportions. Some neighbours have one out of 8 houses in foreclosure. Citywide, the total last year was one out of 32.

Where do these people go? They rent, naturally. Rental vacancy rates have fallen from 10% two years ago to 5% today

Meanwhile, from Manhattan come two bits of conflicting news: apartment sales are down to an 18-year low... but prices are at an all-time high. Buyers are holding back, in other words... but sellers hold out too - for more money.

Across the nation, repossession filings are up 93% from last year. And as we saw yesterday, food stamps are up big time. But there really aren't any "stamps" any more. Now, the food comes via plastic, a type of credit card that can be used - theoretically - only for buying food. In practice, nice shopkeepers in bad neighbourhoods take the card and give back cash at steep discount. Say a $10 charge for 7 bucks worth of cash to buy life's real necessities - liquor, cigarettes and gas.

It's all going according to plan, as we see it. The empire is rolling over. Now, in its advanced, decadent phase, the imperial government must provide bread - in the form of plastic food stamps... and circuses - in the form of national party conventions, elections and foreign wars. The combination settles the public... and distracts them. They become docile, subservient, willing to stand in line to protect themselves from make-believe threats ... and ready to put up with any nonsense, no matter how grotesque, absurd or faithless.

In the latest financial news comes word of new proposals to "regulate" Wall Street... and new initiatives to "save" homeowners. The free market is out. 'Public responsibility' is in.

Treasury Secretary Paulson:

"I think you will continue to see flexibility as we learn and go forward,'' changing his tune from last month when he said proposals to use government funds were a "non- starter."

Why are they a starter now? People come to believe what they must believe when they must believe it, is our observation. Both private citizens and the government too have taken on obligations that they can't possibly fulfill. Since it cannot be paid, the debt must be made to disappear. The world - or at least most of the Anglo-Saxon part of it, must be de-leveraged. So, people must believe in a fantasy about how the government will "bail out" the homeowners... and how the Fed will "rescue" Wall Street.

How could they perform such miracles? When a man cannot pay for his house, can the feds make the mortgage disappear? When Wall Street has blundered -forgetting to sell its cheesy debt before it started to stink - what can the feds do about it? All they can do is to spray some deodorizer around the room

Still, the voters have been conditioned by television, public education, and maybe something in the water; people will believe anything. And what they need to believe now is that the feds can somehow ease their hurt. This will make it possible to shift the debts that cannot be paid onto the government, where they will not be paid.

Among all the great debtors in the U.S.A., circa 2008, only one has the power to pay its debts - no matter how large they are. Only one has printing presses that turn out pieces of paper with pictures of dead presidents on them. And only one can trade bad debt for political favor. That one is, of course, the U.S. federal government... lender of first, last, and holiday resort.

Already, the Fed has taken onto its balance sheet some $30 billion in smelly collateral from Bear Stearns... and billions more from other financial institutions. That is just the beginning. Somehow, the whole shebang of mistakes, misjudgments, greed-stoked miscalculations will end on the shoulders of the U.S. Treasury... on the backs of U.S. citizens... and dollar holders all over the world.

Bill Bonner
The Daily Reckoning Australia

• None Found

"Yecch," it said. And so "Hell Week" continued.

Despite the Fed's intervention, in both London and New York the cost of money for most borrowers actually went up.

"Fed cuts fail to lower 30-year mortgage rates," notes the Los Angeles Times . At the long end of the yield curve, rates are determined more by fear of inflation than by the Fed's price fixing. Thirty-year fixed-rate mortgages have gone up from 5.6% to 6.4%.

But even at the short end, where the Fed is pressing its fat thumb on the scale, "Money market rates rise as banks hoard cash," says a Bloomberg report.

The banks are holding onto their money because they figure they might need it. That's what everyone does in the opening stages of a credit contraction. They're afraid that if they lend it out...they will later discover that the borrower can't pay it back.

Yesterday brought news that two big borrowers had gotten whacked. Endeavor Capital lost 28% trading Japanese bonds. And poor John Merriwether! Almost exactly 10 years ago, the man's Long-Term Capital Management went broke. Now, the news tells us that his bond fund has just taken a 24% hit.

And Britain's biggest mortgage lender - HBOS - denied rumors that it is having liquidity problems.

The Fed giveth.
Mr. Market taketh away.

It's "the Great Unwind," says Citigroup. What is being unwound is the ball of debt, derivatives, speculation and outsized asset values all over the world.

The Dow fell yesterday - down 293 points. Commodities got whacked hard too. Oil lost nearly $4 a barrel. Gold dropped to $945. And copper - which tends to be an indicator for the whole economy - seems to have topped out.

In terms of our 'battle' between inflation and deflation, yesterday, deflation won.

*** In spite of all the bad news, Hell Week hasn't really been so bad. It's more like Purgatory or Limbo...or a halfway house after coming out of state prison.

The headlines speak of a worldwide financial crisis, but so far, the effects of this crisis are extremely limited. The OECD reports that unemployment around the globe is only 0.3% higher than it was a year ago, the same figure U.S. unemployment has risen during that period.

Aside from panicky capital markets, some areas don't seem to be suffering at all. Latin America, Asia, the Gulf, and Africa all seem to be growing, with no significant economic effects - at least, not yet.

The Financial Times summarizes the outlook for the world's major regions:

In the United States, people wonder how hard the landing will be.

In Europe and Japan they wonder whether the landing will be hard or soft.

In the rest of the world, they ask whether they will have a landing at all.

America's central bank is now lending money at about half the rate of consumer price inflation. A borrower can take the money and almost certainly make money. If nothing changes, he'll pay back money worth less than the money he borrowed...or, he can put it on deposit in Britain at twice the yield...or in Brazil, where he'll get 5 times the yield.

The lower rate is intended to encourage borrowing. Whether it also encourages consumer spending, hiring, and capital investment is another whole group of questions with very uncertain answers. If the answer is yes...you can reasonably expect further inflation in the commodities markets...rising stock prices...and a positive GDP growth. If the answer is no...you can expect higher unemployment, falling stock and housing prices...and probably falling commodity prices too.

While yesterday was clearly a 'no' kind of day...there is no guarantee that every day will be a 'no' day.

Another way to look at this is a way long time Daily Reckoning sufferers will recognize: it is our familiar battle scene...with the heavy cavalry of inflation charging the steadfast infantry of deflation.

While that picture has fairly well described the financial world for the last year or so...we think it is time to add a complicating feature. It is as if a third army has appeared on the field of battle...of unknown size...and unknown intentions. So let us review the battle lines.

On the one side, is the familiar force of a credit cycle downturn...believed, by us, to be the beginning of a major contraction in the credit market. These things are big. The last big force in the credit world was the expansion that began in 1980. Obviously, it lasted for 25 years, perhaps a bit more. That expansion seems to have come to an end. Yields are about as low now as they were when the last expansion began...and probably turning up.

That "probably" is an important word. Recently, yields have been going down, as investors sought safety from default over safety from inflation. Looking for protection in the treasury market seems to us a bit like looking for veracity in the U.S. Congress...and we suspect that when things settle down, investors will realize they've made a mistake.

"The credit crunch is rapidly morphing into a credit collapse," says Harvard's Kenneth Rogoff. "The same factors that propelled the housing bubble are now spinning in reverse. And there's no bottom in sight."

On the other side, of course, is the other familiar force - inflation. It's what you get when you favor the production of 'money' over the production of the things it is used to buy. Inflation is clearly driving up some prices. Oil is holding over $100. Gold has been on a tear for 8 years. Rice just hit a 32-year high. CNNMoney reports that inflation is Americans' number one concern.

Meanwhile, keeping our pict-o-rama of the world's financial scene before us, with inflation on the left, deflation on the right, down the center comes a huge, disorganized, polyglot collection of fighters - lean and hungry - emerging markets, oil producers, former Soviet republics...the bric-a-brac of humanity.

While deflation knocks down commodity prices - these emerging economies are buying them as fast as they can.

While inflation is pushing up automobile prices - they're making new cars for only $2,500.

While deflation cools the U.S. economy - these third world economies are still heating up.

While inflation squeezes aging, middle class families in the West - in the East, millions of young, new families are becoming middle class, bursting at the seams with new consumer demand.

What will happen when these three armies collide?

We don't know...but we're watching...

*** Mentioning 1998 brings back memories. That was when people still believed the promise of the dotcom era. They thought new technology and capitalism would make them all rich. They ran up prices on Wall Street in anticipation.

And then we came up with a hypothesis: that when the tech bubble burst, the U.S. economy would sink into a long, slow Japan-like slump. With Addison, we wrote a book on the subject - Financial Reckoning Day - arguing that central bank wizardry might be able to stop inflation, but it had never proven that it could cure a deflationary slump. Even a bad central banker can stop inflation, if he has the backbone for it. The reason for this is almost too obvious; central banks can stop inflation because they are the ones who create it.

But deflation is the markets' revenge...and central bankers have never shown they can stop it once it gets going. That is what we learned from the Japanese in the '90s. You can use all the fiscal stimulus you want...and all the monetary stimulus too. It doesn't mean the economy is going to pick up.

We're beginning to think we were right in Financial Reckoning Day . Or almost right. Yes, dear reader, we said that after the tech bubble popped, the U.S. economy would enter a long, slow slump, a al Japan. Obviously, we were too early...there was one more big bubble still to go - in residential property. But now that that bubble has come and gone, here we are again - possibly facing another Japan-style funk.

*** "It's no secret: Homebuilding stocks have performed horribly," says our colleague Dan Amoss. "Most are 60% or 70% below their highs. A few regional builders are in the low single digits, drowning in debt and heading to zero."

"But stocks never move in a straight line. The sector has enjoyed a massive short covering rally since late January. Most are up 40% or more in a few weeks. This gives us a good short selling opportunity.

"Homebuilding bulls are hoping for a quick housing market recovery, because they need one for the stocks to have a sustainable rally. This spring, as selling season kicks off, you'll start hearing 'affordability' arguments from housing bulls in the media. I suggest ignoring them.

"Housing bulls fail to appreciate how the easiest mortgage environment in history magnified every homebuyer's purchasing power. They also focus on monthly payments in a 5-6% mortgage environment, without incorporating the burden of falling house prices. Incomes and 5% mortgages can support housing prices in many areas of the U.S., but not in areas like Las Vegas, Phoenix, and most of California and Florida.

"Measured over a full boom-and-bust cycle, homebuilding is not a great business. Even at the peak of the housing bubble, most builders' operating profit margins maxed out at 15%. This business is capital-intensive and requires a rising house price environment to thrive. The most aggressive homebuilders loaded up on raw land at inflated prices and levered their balance sheets with visible and hidden debt. Now most are liquidating inventory as fast as possible, even at steep losses.

*** What are they putting in the water in New York? Has no one any sense or dignity?

First, Eliot Spitzer confesses to a mortal sin and resigns his post as governor of the state. Then, his replacement goes before the cameras to make a similar admission - even before he's accused of anything.

Then, it gets even tawdrier. His wife, for no apparent reason other than to frolic in the sewer with the two governors, revealed that she too had done things that would make her eligible for death by lapidation in other countries. But this is New York, remember. She'll probably go on Oprah instead.

And, as if all this weren't absurd and pathetic enough, we discover that New York's new governor and his wife went to the Days Inn on upper Broadway and 94th Street in order to bring more excitement to their married life. The Days Inn?

At this point, your editor notices his stomach seizing up...and beginning to convulse. He doesn't know whether he is going to laugh, or be sick.

Until tomorrow,

Bill Bonner
The Daily Reckoning

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