..how does it all work? We're doing some serious thinking this week. What is it that actually causes a depression? A stock market collapse? Or too much debt? How come government can appear to cure the problem sometimes - 2001-2007 - but not other times? How come the Japanese were not able to increase consumer prices? Even now...Japan's inflation rate is negative. And why is it, despite the most massive effort at monetary inflation ever undertaken, the US bond market still forecasts an inflation rate of less than 2%?

An interview with Richard Koo, author of The Balance Sheet Recession, and a new book by Ken Rogoff and Carmen Reinhart are helping us understand what it going on. More to come...

In the meantime, the Dow went down 42 points on Friday. Gold dropped $7. Still no sign of the Chinese coming to the rescue in the gold market.

"Global rally shows signs of running out of steam," says The Financial Times.

Reuters says the job data will "test the rally." The New York Times says the ratio between job seekers and jobs available has never been worse.

The Wall Street Journal, on the other hand, tells us that greater than expected profits will support the rally. So far, the increase in stock prices has not come from increased earnings. It's come from increased P/Es...based on the hope of higher earnings. In terms of forecast earnings, the Dow is selling at a P/E ratio of 27. But in terms of actual, reported earnings...the ratio if 180.

A friend made the mistake of asking us what to expect from the economy. We said it would go do down.

"You mean, you expect a W-shaped recovery," he said... "A double-dip recession?"

"No...we expect no recovery at all. It's a 'W' without the last stroke..."

Of course, we were exaggerating. But not much. We do not think that the economy of the Bubble Era can ever be revived. It will never recover...because it is dead.

But that's doesn't mean we will march backward forever. The economy may lose 10% of GDP...maybe 20%. But we do not expect to be slithering in the mud of the Middle Ages, with each man is planting his own wheat and brewing his own beer. No, not at all. It only means that the depression must continue until it comes to an end.

"But when will it come to an end?" you ask.

"When it is over."

A depression ends when it has done its work. It must correct mistakes. It must punish errors. It must destroy the bubble economy...and the mindset of the Bubble Era. Only then can new real, sustainable growth begin again.

So far, in 2009, 95 banks have gone broke. How many more need to go broke before the depression is over? We don't know. This is where is gets complicated. Because the feds are determined to keep us from finding out!

Here's how it works. The Fed lends the bankers money. Then, the bankers turn around and lend it back to the feds. The banks are happy; they're making money on a risk-free trade. The regulators are happy; what could be safer in a bank's vault than US Treasury bonds? Investors are happy; it looks like the financial sector is making money again. And the feds are happy; they're able to finance their deficits.

Who's not happy? So far, so good. But hold on...

"This is not a sustainable recovery," says fund manager Crispin Odey in The Financial Times.

What a spoilsport! You mean you can't build a lasting recovery on debt and shell-game finance?

Nope. Apparently not. Just look at what has happened to the auto industry. The feds borrowed money to help Americans pimp their rides. And this Thursday, when September sales figures come out, we find out how sustainable that boost was. Many Americans got new wheels. But now they don't need new wheels. And now the feds are out of the auto- incentive business. So now we get to see what happens next.

Stay tuned...

Bill Bonner
for The Daily Reckoning Australia

• Krugman Warns That the Run-up in Stocks Can’t Be Justified By the Fundamentals
• No Evidence of Recovery as Unemployment Getting Worse
• We Don’t Expect to See Australian Banks Suddenly Keen to Expand their Loan Books
• Where, Exactly, is this Economy Headed?
• Feds Can’t Cause a Genuine Recovery Simply by Throwing Money into Economy

"Stock markets disoriented by the uncertainties of the recovery..." says an awkward headline in today's French financial news.

The Dow itself lost 212 points yesterday. Oil fell to $66. Even gold dropped $10 as people fled back to the only asset they know they can count on - the U.S. dollar. Or more precisely, U.S. debt denominated in U.S. dollars.

Come Hell or high water, the Treasury will come through. When it's time to pay the coupons, they'll have the cash. You can count on it.

But what you can't count on is how much that cash will really be worth. And there lies the great trap for the lumpen investoriat. The lumpen, as you know, get their investment ideas from TV and the newspapers. The poor rubes are the last to buy in a boom and the last to sell in a bust. A day late and a dollar short, they always get the worst deals. When the papers tell them there's a recovery - they believe it. When the Fed chief tells them to use adjustable rate mortgages...the silly clumps do it. When a governor of a Federal Reserve banks urges them to "go out and buy an SUV" they head for the dealers.

But thank God for these patsies. Without them, where would we get candy? And where would the U.S. government get its trillions?

The lumpen - along with the sophisticated fund managers who pretend to know what they are doing - are financing the biggest government- borrowing spree in the history of mankind. You don't have to dig too deeply to figure out why that won't work. Financing a little spree of borrowing may turn out well; financing a big one is asking for trouble. Each dollar you lend weakens the borrower's balance sheet. By the time he has gotten to the 12 trillionth dollar...you might as well be throwing the money down a well.

And thank God for Arnold Schwarzenegger. What an entertainer! He had it all. Money. A good wife from a bad family. A nice hairdo. And what did he do? He gave up a promising career in the motion picture business to launch himself into the slimy world of politics.

And now the poor man is groveling. Begging. Imploring the banks to take his state's IOUs. He says they are "rock solid." California is the world's 6th largest economy. But it was a world-beater when it came to debt-based bubble illusions. And now its economy is falling apart. Economists can lie about the inflation rate. They can fudge the GDP. They can torture the unemployment numbers. But when the revenues come in, all they can do is count them up. And revenues are falling. Especially tax revenues.

The feds and the states are losing income. When businesses lose revenue they cut back expenses. But governments - at least those that are modern popular democracies - find that they need to increase spending. They have more people asking for help. And they have programs that become automatically more expensive - such as unemployment benefits - when the economy softens.

Let's see. Expenses down, income up = happiness.

Expenses up, income down = misery.

See how simple it is?

Until tomorrow,

Bill Bonner
for The Daily Reckoning Australia

• Aussie Dollar is Crushing Long-time Rivals Like the Pound and the U.S. Dollar
• Saving Money, Not Spending it, is the Key to Getting Wealthier
• I.O.U.S.A. the Movie Opens in 358 Theatres Across the Nation
• Warren Buffett: People Do Not Make Money by Betting Against the US Economy
• Citi Reports $4.69 Billion in Fixed Income Trading

It's that last item that puzzles us.

People are buying Treasuries for safety. Money markets, which hold short-term Treasury bills, are at record levels. We understand why you might want to have money in a money market fund...but where's the margin of safety in a 10-year note paying less than the rate of consumer price inflation? Even in the money market funds, you'll lose money when the dollar goes down - whether it goes down against other currencies or against consumer items. And what do you get in exchange for the risk? Not much. The 91-day T-bill rate is only 1.66%.

Currently the inflation rate - according to official statistics - is near 5%. Buying a 10-year note at a full percentage point lower is not a safe investment - it is a speculation, a bet on the direction of rates in the future. If they go...the value of the T-notes goes down.

Lately, that's begun to look like a reasonable bet.

"Falling prices ease worries about stagflation," says a headline in the International Herald Tribune . Oil is down about 15% from its peak. Food has fallen a similar amount. Could it be that inflation has topped out? Could it be that the "civil war" between inflation and deflation is finally reaching a conclusion...with deflation the clear winner?

Could be. Then again, it could not be.

"The question for investors is whether the slump in oil and commodity prices will last or is simply a temporary retreat brought on by overstretched increases," continues the IHT . If the increase in prices won't last, we can all forget about girding our loins for the fight against inflation. We can simply buy Treasury notes and wait for the current downturn to pass, right?

Maybe. Maybe not.

Inflation is at about two and half times the Fed's key lending rate. Overseas, many countries are facing much higher rates. Russia has an inflation rate of 14%. China's rate is over 7%. Inflation in India is running about 12%. And Dubai has inflation at 22%. Dubai, by the way, is a bubble. It has only .02% of the globe's population. But it is home to 10% of the world's construction cranes and seems hell-bent to prove to the world that there are bigger fools than Americans - as if that needed proving. It now has the world's only 7-star hotel...and the world's tallest building too. In the harbor, it's building a series of artificial islands in the shape of a map of the world.

The gods must be watching...and getting ready to teach Dubai a lesson. What would it take to kick Dubai in the pants? A lower oil price...

For the last few weeks, oil has been going down...and the news has been overwhelmingly deflationary. The S&P is down 14% for the year. The credit crunch continues to pinch businesses and investors. This morning, we got news that Merrill Lynch announced $5.7 billion in write-downs. Wall Street will hand out an estimated $10 billion less in bonuses this year. Mortgage-backed securities are selling at only one-fifth the rate of a year ago. And the IMF says there is "no end in sight for the credit crisis."

Now, it's beginning to hit the wealthy, too, says the Financial Times. Prime mortgage delinquency rates are increasing. So are late payments among the best credit card customers. AMEX, which targets good-quality borrowers, saw its earnings fall 37% in the second quarter.

Meanwhile, investors are selling stocks short at record levels. The pros think stocks are a bad bet. This puts the stock market under a lot of tension. A rally to the upside can be explosive, as the shorts need to buy in order to cover their positions. On the other hand, the pros may be right; deflation is a big threat to stocks. The amateurs may be right too - they're moving to cash and bonds.

Cash is probably a good move. You're protected against defaults and write-downs. And you can take cover if inflation gets worse. Moving to bonds is another matter. They are a leveraged bet against inflation. And yes, for all we know inflation is dead forever. But we wouldn't want to bet on it.

Bill Bonner
for The Daily Reckoning Australia

• Arab Wealth Pours Back into Dubai
• Qatar Relies on Natural Gas Reserves While Dubai Leans on Trade and Finance
• Deflation is on the March
• Is Dubai the Bubble It’s Made Out to be?
• BRIC – Brazil, Russia, India and China Suffer High Rates of Inflation

And what we reckon today is that two extraordinary things happened yesterday – related to one another and equally absurd.

Yesterday, the Fed did what it was widely expected to do – it lowered rates by 25 bps, bringing the key Fed lending rate down to 2%, or about half the rate of consumer price inflation. And that is where we begin to wonder. What kind of a bank would lend money for less than the inflation rate? Isn't it sure to lose money?

Yes, of course...but it's a long, long story...

The other extraordinary thing that happened was that the U.S. federal government began sending people "tax rebates." Of course, they are not tax rebates at all. Everyone who filed a tax return will get $300, whether he owed any taxes or not. A taxpayer will get another $300. Plus, children and dependents will get $300 each.

Alas, today's news tells us that much of the presumed benefit from the giveaway program will be lost because of higher fuel and food prices.

(And here we offer some helpful advice: We've heard that SUVs aren't selling very well anymore. Maybe the feds should give every family an SUV – one made in America, of course. That would be good for the auto industry – and then people could take the money they save from not having to buy a new car themselves and use it to buy gasoline and groceries.)

The U.S. government is already $9.3 trillion in debt (not to mention the other $40 trillion ‘financing gap'). It is giving out money it doesn't really have – $106 billion worth. But it is doing so for good reason – or so it believes. The president of all the Americans – George W. Bush – said that the handouts will be "good for the consumer economy."

Lending money below the inflation rate...giving out money you don't have, when you are already so deep in debt you will never get out – how could any of this be good for the real economy? But by this time we are so far into Never-Never Land that we will never find our way back.

A consumer economy may benefit from consumer spending – but only if consumers have money to spend. If giving away phony money, which you don't really have, could make things better – why stop at $300 a head? Why not give away $1,000 a person...or $5,000?

Likewise, if it's a good idea to lend money at 2% below the inflation rate...why not lend it at 10% below the inflation rate?

The really extraordinary thing is that the brightest minds in the nation think they can control the economy in these extraordinary ways. But they would think so, wouldn't they? The guy who believes drinking doesn't affect his driving is always the guy with the whiskey bottle.

Meanwhile, there was some ordinary news yesterday too. The Dow eased off 11 points. The euro stayed at $1.55. And gold lost another $11 – dropping to $866. Wouldn't it be nice if the price would fall below $800! Maybe it will; maybe it won't. But Dear Readers are urged not to lose heart. This bull market in gold isn't over yet. The real excitement is still ahead.

Bill Bonner
The Daily Reckoning Australia

• Investors Feel They Can Put Their Money into Treasuries and Not Worry
• The Inflation Rate in India is Running About 12%
• Lending Rates Will Go Up With Inflation
• Japanese Practically Gave Away Money to Anyone Who Would Borrow It
• In Europe, Banks Borrow Money and Lend it Back to the Government